Pyramiding...should investors Average Up rather than Average Down?
The opposite of Averaging Down is, you guessed it, Averaging Up - the process of buying shares in a company and then buying some more as the price gets higher. Often called ‘pyramiding’, this approach is particularly popular amongst classic momentum investors like Bill O’Neil and Jesse Livermore. Even some of the biggest disciples of value investing have done it. Warren Buffett started buying Berkshire Hathaway when it was $7.60 in 1962. He kept buying even after it had risen to $14.86 in 1965. Averaging Up could raise the average price that investors pay for their stocks and seems to go against the principle of buying low, selling high. So why do investors do it?
What are the advantages of Averaging Up?1.Managing Risk
In the first instance, investors can limit the average price that they pay for stocks by making smaller and smaller purchases as the price gets higher - such that one’s purchase sizes resemble a pyramid. For example, rather than buying 100 shares at £100 and another 100 at £200 (average £150), they could instead buy the first 100 at £100 and another 50 at £200 (average £133).
If the first trade turns bad, risk can be limited as you’ve not bought a full position size, while you only unfold your full exposure if a stock ‘acts’ well and rises.
2.Investing with momentum
Trends have had a historical tendency to persist in the stock market. This is known as the momentum effect. Research which looked at data between 1945 and 2008 found that a strategy that went long recent winners and short recent losers (i.e. top and bottom 10% of stocks ranked by 1 year price performance) returned an annualised 16.5% with remarkably low volatility.
Momentum investors argue that pyramiding purchases are made on a less risky basis because the first entry is smaller, so investors would have less exposure to a falling stock. Furthermore, later purchases are only made after a stock shows signs of having strong share price momentum. One’s average purchase price is higher, but, according to Livermore et al, the stock is behaving correctly. Momentum investors argue that Averaging Up is less risky than Averaging Down.
What are the disadvantages of Averaging Up?1.Transaction costs will be higher
Brokerage charges would of course be higher if investors traded more frequently (ie. when the price goes up) than if they were fully invested at an earlier stage. If you make four purchases rather than one you’ll have four times as much commission to pay. See our article on managing trading costs for more details.
2.Higher cash balance and higher purchase price
Investors would need to set cash set aside, ready to buy additional shares if they were planning to Average Up. Portfolio returns would therefore be more sensitive to market performances later in the horizon, when the investor is more fully invested. This could potentially lead to lower returns if one’s average purchase price were higher. Pyramiding investors argue that the benefits of risk control outweigh the risk of higher costs.
3.The trend may go against you
Stocks have had tendency to continue trending in the same direction for periods of three to twelve months. However, things are not always that straight forward. There could be an unexpected bear market and the world could end tomorrow. Problems would of course arise if large downwards price movements occur and the stock position became ‘top heavy’ with shares that were bought before the price collapsed. If this happened, the potential losses on the newer additions could erase all profits that the preceding entries made.
Conclusions
So when all is said and done, what are the pros, what the cons? On the plus side, momentum could be on the side of investors who Average Up, and investors can limit the price that they pay for a share if they buy shares in smaller numbers as the price gets higher. The disadvantages are that tradings costs would be higher and investors may be holding cash while a share, or the market, goes up.
Read More about Berkshire Hathaway Inc on Stockopedia
Discuss Berkshire Hathaway Inc on Stockopedia
