If you've ever bought shares and then watched them fall heavily, then you'll be familiar with this situation. What should you do? A big loss seems inevitable, but you don't want to make it any worse than necessary.
The good news is that these losing trades can sometimes be converted into big winners, if you keep a cool head and take the right approach.
Here's an example
By mid-summer last year, shares of mining group Anglo American had fallen by more than 70% from their 2011 high of 3,421p. They were trading at a significant discount to book value and -- according to my notes at the time -- at less than 10 times Anglo's 10-year average earnings per share.
Although I was still concerned by Anglo's high debt levels, my view was that the shares were probably undervalued on a three to five-year view. So I added some to my portfolio at 900p. What happened next is that they continued to fall, finally bottoming out at an all-time low of 215p in January. Ouch.
There were three ways to handle this situation. Buy more, hold, or sell.
I could have sold once the shares fell to a certain level below my buy-in price. This stop-loss approach is often used by growth investors and momentum traders. Personally, I don't like it. It doesn't fit well with my focus on value investing. After all, if a company is cheap at 900p, then it should be even cheaper at 450p. Why sell?
I could have done nothing and simply waited for Anglo's share price to recover. Patience will often bring a profit, and that's what's happened here. Less than 18 months after my original purchase, Anglo shares are trading at about 1,110p. I'd be sitting on a 23% profit at current prices.
However, what I actually did was to buy more Anglo American shares. I waited until I thought the stock was priced for failure. I then bought more at 378p, reducing my average purchase price to about 620p. This technique is known as averaging down.
My decision to average down on Anglo American means that I'm now sitting on a 76% profit, despite the poor timing of my initial purchase.
The secret to success
Averaging down isn't always a good technique. If the company you're investing in isn't significantly undervalued or has financial problems, then the shares may never recover. Averaging down also means that you increase the size of your position in a stock. This can mean that it becomes too large a part of your portfolio.
The secret to averaging down successfully lies in being able to form your own opinion of a company's value, using hard data such as the balance sheet and cash flow statement. Doing this does involve a certain amount of work. It may also take several years for the value you detect to be reflected in the company's share price.
If you're confident in your valuation, then averaging down can provide a serious boost to your future profits. It's definitely a technique worth adding to your investment toolkit -- just use it carefully.
Don't make mistakes
Averaging down is a technique favoured by value investors. But regardless of your investment style, I'm certain that you'll want to avoid the costly mistakes described in our exclusive new report.
Worst Mistakes Investors Make contains details of a common investing mistake that can lead to big losses. If you're concerned about the potential impact of the US elections and Brexit on your portfolio, then I'd urge you to read this.
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Roland Head owns shares of Anglo American. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.