Managing The Risk Manages The Returns And The Recovery Of Your Investments

By Miles Clyne

Warren Buffett once scribed:

 
I call investing the greatest game in the world because you never have to swing. You stand at the plate, the pitcher throws you GM at $47, U.S. Steel at $39, and NOBODY calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it!
 

Longer term, I believe this is absolutely the best investment strategy. Regrettably, participants seem to feel the need to be busy all of the time.

All of our research suggests that Warren was mostly correct. The logic/math is really simple, even in a worst case scenario buying quality, regardless of what happens makes huge sense, and being busy at the right time is far more important that being busy all the time. For instance, if in your portfolio you buy an investment that is trading at $100 a share, and then the market tumbles, and your investment drops in price to $50 per share. The table below shows how averaging down lowers the cost of your shares, which can ultimately be a very intelligent decision.

 
 

The investment you originally paid $100 for, now has an average cost of $75. What’s the big deal you wonder? If you do nothing, recovering from $50 to $100 requires a 100% gain on the investment. Getting from $75 to $100 only requires a 33.33% gain. It shouldn’t require Warren Buffet to tell you that getting a 33% gain is a lot more likely than a 100% gain. If the investment does recover to $100, you will have made a 25% gain on your money as opposed to zero by not averaging down. As well the recovery would most likely be a lot quicker given you are already 66.66% of the way there. 

Another benefit is if you like income from your investments. Averaging down can give you a nice raise. If the investment had a yield of 3% prior to the correction, averaging down as in the example above would increase your income by 50%. Income investors often overlook this fact, only seeing the loss, not the opportunity. 

 
 

Important caveats to take this approach are that you need absolute confidence in what you own, and have the capital available to average down. A properly managed portfolio would have covered off these issues.

What do we know about the future?

We don’t know when or to what degree markets will correct, only that they will. Fearing market corrections is like being afraid of your shadow. Deal with your fear by knowing what to do when the inevitable happens, or deal with someone who will make this happen for you. Alternatively, your emotions can get in the way of making good decisions in both good and bad markets. 

Logically, the big money is made in the markets from the bottom up, not from the top down. Be a Scout, be prepared and in control!