John Hempton has a very interesting post on when to average down into a stock.
As a summary, one should not average down into a stock if
- a company has a lot of financial leverage
- a company has significant operating leverage
- the company is in danger of becoming obsolete
I think this is already a pretty good advice, as a counter example he gives Coca Cola where one can average down “without much risk”. As this is a very interesting topic, I wanted to contribute my 5 cents to this:
Behavioural biases at work
In my experience, averaging down is often motivated by a couple of behavioural biases.
The major bias which “helps” investors and especially professional ones to average down in the wrong cases is in my experience the “over confidence” bias.