I tried to explain the concept of “averaging down” at my last annual meeting, but I couldn’t quite get my point across as well as I’d hoped. I was trying to throw too many concepts out there all at once. I’m going to try again here, as I spent a lot of time this summer averaging down in the Tarpon Folio, so it’s been on my mind again.

The idea that “lowest average cost wins” when it comes to investing is one of the most under-appreciated elements of portfolio management. And my own averaging down in Tarpon has been a very significant contributor to our returns. So I believe this is an important subject for all investors to grasp.

My theory is also that using FOLIOfn to average down is also a big advantage for portfolio managers. To understand why, you’ve got to know a little about the following four concepts:

1 – Averaging down. I define this as buying more new shares of a stock when it is trading below the average price you paid for your existing shares – while keeping the total weight of that holding constant in your portfolio. So, you’re buying new cheaper shares and selling older more expensive shares. This is synonymous with lowering the average price you paid for that stock.

2 – Tax lots. Think of a tax lot as a price tag that is wrapped around a bundle of a company’s shares that you bought at one particular time. I’ll try to explain this with an example.

Let’s say on every Tuesday of the past July, you bought 10 shares of Google. At the end of the month you owned 40 shares.

Now you want to sell 10 shares out of those 40. At most brokerage firms and mutual funds, you have no say in which ten shares you sell. That’s a bummer, because you could save a lot of money in taxes if you could select the shares you wished to sell in a way that, if your shares had gone up in value, would minimize your capital gain. And had you the option, if your shares had gone down in value, you could create a bigger tax loss (which is good, because it offsets other gains at tax time) by selling those shares that you’d paid the most for.

Again, at most brokers, you have zero control over which ten shares you sold. Fortunately, though, on FOLIOfn, you can sell shares in a tax-savvy way via tax lots.

So in the example above, you have four taxes lots – one for each bundle of Google shares you bought on Tuesdays. When it comes time to sell one of the bundles, FOLIOfn allows you to easily pick the best one to part with by comparing the price tag on each bundle to the current market price. And that can save you a ton of money when it comes to taxes.

3 – Fractional shares. FOLIOfn also allows you to buy fractions of a share. It may sound odd, but say you only have $400 to invest. At most brokers, you couldn’t even buy a single share of Google if it was trading at $535 each. At FOLIOfn, though, you could buy 0.748 shares of Google with your $400 – no problem at all.

4 – Percentage weightings. I manage the Tarpon Folio according to percentage weights. So, for instance, if I wanted to initiate a new position in Google in Tarpon, I’d tweak the core portfolio settings to, say, reflect a (6.0% weighting by dollar amount) in Google. FOLIOfn’s system then interprets that weight into the exact number of shares (and fractions of shares) to buy in each investor account to bring their accounts up to a 6.0% weighting in Google, too. So, it’s a simple concept that plays into things subtly more here in a minute.

Now, here’s an example of why it pays to average down:

On Monday I buy a single share of stock in Pork & Beans Co. for $10.00.

On Tuesday, a customer opens a can that contains neither pork nor beans, but something that can only be described as sinister. Panic ensues. Shares drop.

On Wednesday, I decide to average down, and buy another single share for $5.00.

Now I own two shares, and my average cost is $7.50 ($10 plus $5 all divided by 2). My total position size is $15.00 (the $10.00 share plus the $5.00 share).

On Thursday, I remember that I only want to have $10.00 total invested in this company’s shares, because for risk control reasons I don’t want it to be any bigger than a 10% position in my $100 total portfolio. There’s really no telling what else has been going on in that factory, it being majority-owned by Goldman Sachs and all.

So, to restate – I have $15.00 of my money invested in Pork & Beans Co., which also represents a 15% position in my total portfolio. But I want to get my ownership of that company down to a 10% position in my portfolio, and that means I’ve gotta sell $5.00 worth of shares.

If to do that I just sold the same single $5.00 share I’d bought on Wednesday, then, well, that would be dumb. Not only would I have paid money (for no reason) in commissions to buy and sell that share, but the other share I continued to own would still have a cost basis of $10.00. So after all that I’d still be eating a loss on paper and would not be any closer to clawing my way back whenever the panic subsided and the shares rose in value.

FOLIOfn, however, effectively lets me sell $5.00 worth of shares by selling half of the $10.00 share I bought on Monday – a move which maximizes my loss on that sale, which is good come tax-time. It also lowers my average cost basis, too, because afterwards I would own the 1.0 share bought at $5.00 and the remaining 0.5 shares I’d bought at $10.00. And that means I would have my ideal 10% position in Pork & Beans at an average cost basis of $6.67 ($10 total position divided by 1.5 total shares).

So, long story short, because I averaged down, my cost basis went from $10.00 to $6.67 on that 10% position in my portfolio.

A month later, a private equity firm comes along and buys out Pork & Beans for $17.00 a share. If I had not averaged down and just kept that original $10-per-share cost basis on the books, I would make $7 in profit, or a 70% return. Not too bad at all.

But because I averaged down to $6.67, though, I made $10.33 in profit, or a 155% return. Now we’re talking. Plus, Goldman was secretly short Pork & Beans stock, so that feels even better.

I greatly simplified a few things above, and completely glossed over wash sale rules, but my point is that the kind of performance differential that averaging down can create is, to me, well worth the trouble – and particularly when we don’t have to pay commissions on any trades at FOLIOfn, period. And again, those aren’t just better numbers for the sake of being able to talk about better numbers. That’s a real increase in actual profit for investors in my Spoke Fund®.

That said, please note that if you aren’t really confident in your own valuation of a company, you
probably shouldn’t attempt to average down. All of the above is meaningless if the stock price doesn’t eventually head back up. If the price instead keeps going down as you average down, you will wind up both broke and insane. The above also implies you’re willing to let your winners run, as they say. To average down and capture a price drop, only to then rebalance your position (i.e. sell some shares off) once its price climbs back up, means it might not be worth the trouble, either.

But if you can stay rational when prices drop for temporary reasons, and you’re a long-term buy and hold investor, averaging down can be very smart for your portfolio.

Update: To clarify, the 1/2 share I’m selling was a $10 share. I am taking a loss there, and I did not net that loss out against the improved gain percentage above. Call it mental accounting…I view that loss as something that can be spread over the entire portfolio come tax time. So, all things being equal, it will likely be a shield of sorts for other capital gains in the portfolio. And I am completely ignoring wash sale rules on purpose in the example above, but a good future post would probably tie it all together here.