Opinion Piece - September 4 2009
There is a general belief among most traders
that the worst mistake any investor can make is averaging
down. Many investors fall in love with their stocks and as
the stock declines they continue to purchase additional
shares. Often investors tend to be unwilling to admit a
mistake in their stock selection. When the stock declines
they continue to purchase. Another problem is when a stock
declines and the fundamentals change, many investors believe
the stock may recover and in an attempt to "break even" they
purchase additional shares. These are just some of the
reasons investors average down.Dennis Gartman, famed author of the
Gartman newsletter, claims that the worst mistake an
investor can make is averaging down on a stock. He tells his
readers that when a stock moves higher, that's the time to
average in. In January 2008, Gartman told the audience at
the Toronto Financial Forum that America had entered a
recession, probably in late 2007. In early 2008 he was short
stocks like Google and RIM and was long Gold, Agriculture
Commodities and Bank Stocks. Gartman has mentioned a number
of times that top traders, such as himself, will be wrong 60
to 80 percent of the time or more. He believes that it is
important to sell quickly when it is apparent a trade is not
working out. He believes that when a trade does work out,
the investor should buy more as the stock is moving in the
right direction.
This is also the basis of Vector Vest. Dr.
Bard DiLiddo uses a momentum approach to tells investors
when to buy stocks. His momentum indicators then tell him
when to sell those stocks as momentum turns.
So what is the best approach to take? In a
bull market the opportunity for gains on most stocks is much
greater. There is some truth to the saying "a rising tide
lifts all" stocks. In a bear market, devastating losses can
result as panic selling can drop stock values by 50, 60 or
even 90 percent or more as we saw in fall 2008 and again in
March 2009. Companies like AIG fell from $493.00 to around
$6.00. In Canada stocks like Manulife (MFC) fell from $40.00
to $9.02. Literally trillions of dollars have been wiped
out.
I believe in averaging down and combining
covered calls and naked puts as the best means of generating
positive returns for investors, but there are important
rules which I believe in. Here are my rules:
1) The most important rule is stock
selection. Stocks have to be large blue chip companies with
strong dividends, solid balance sheets, low P/E ratios, good
cash flow, low debt levels and reasonable payout ratios.
This may seem like a tall order, but these stocks do exist.
2) Set reasonable guidelines as to the
quantity of stock and dollar amounts you want to invest in
any one stock. 15% of your total stock portfolio in one
stock is probably more than enough for most people.
3) After setting your guidelines as to the
amount of stock you wish to purchase, average into that
quantity over time, to take advantage of pullbacks. If not a
retirement account, average into stocks through selling
naked puts.
4) Use the selling of puts to generate
income while waiting for a decline in stocks. Consider
laddering your naked puts if required in order to keep to
the strike point you originally selected. For example if you
wanted to be in a stock at 30.00 and the stock rises to
45.00, you may have to go out 6 months to continue selling
naked puts at the 30.00 strike. Remember that stocks move
around a lot more than analysts might have you believe. A
sudden run-up in a stock can be followed by just as dramatic
a downturn.
5) If your stock declines dramatically,
research the stock to determine if the fundamentals have not
changed. If they have not, you could consider rolling down
your covered calls and going further out in time. You can
also consider placing a collar on your stock. (I will post
another article on collars soon). Try not to sell below your
cost basis however which can lock you into a loss situation.
6) I believe in keeping 30% of my
portfolio in cash instruments in case my stocks should
decline or a new opportunity presents itself. If you examine
my Royal Bank trade
or my Sunlife
trade, you can see that my returns hinged completely on
being secure in the belief that I could average down and add
to my position as the stock declined. If I had not been able
to do this with confidence, then my return would have been
greatly reduced. So while Sunlife and Royal Bank saw
dramatic declines along with other financial stocks, the
fundamentals of both companies remained solid, making the
decision to average down, easy.
7) After averaging down, commencing
selling covered calls immediately in order to protect the
stock you just purchased from further declines and attempt
to generate income to reduce your overall cost basis on all
the shares you have purchased. If you look at my
Sunlife trades here
you can see that I averaged down a number of times as the
stock declined. I then immediately sold covered calls and if
my cost basis was too high for covered calls, I sell covered
calls on the most recent stock purchase.
That's
it. Those are the rules I follow.
