Adding to a Losing Position

I just read an article in the Five Minutes Investing. There are things to avoid when you are investing, and unfortunately, they are mistakes that nearly every beginning investor makes.
One of them is adding to a losing position.

Here's the article:

Another strategic error commonly practiced by many amateur investors is adding more money to a losing position. The reasoning in the mind of the investor who does this goes something like this: "I bought the stock when it was $40. Now it is $20, so it's twice as good a deal as it was at $40. Besides, my average cost per share will come way down once I add to the position."

Sometimes this is called dollar cost averaging - putting an certain dollar amount into a stock at specified time intervals or at specified price intervals when the stock drops in value.

When an investor adds to a position on equal time periods (ie, $1,000 every quarter) independent of the price of the stock, I call it Time-Based Dollar Cost Averaging. When an investor invests an equal dollar amount each time a stock declines in price by a certain level (ie, $1,000 with each 20% decline in price), it is called Price-Based Dollar Cost Averaging - (this practice is sometimes called Scale Trading and is discussed in Chapter 6).

What you need to remember is that while Time-Based DCA can make sense if done in a controlled manner, Price-Based DCA makes no sense in any circumstances and is sure to bankrupt you if practiced consistently.

The rest of this section I want to devote to explaining why you must never practice Price-Based DCA as a strategy, because it is the most destructive of all investor mistakes and represents in the extreme why you should never add to a losing position.

The fallacy of Price-Based DCA can best be illustrated by the following example. Let's assume we have the ability to anonymously observe a certain naive investor, Mr. Jones, who is going to pursue a Price-Based Dollar Cost Averaging strategy.

Mr. Jones picks a portfolio of ten stocks and puts $10,000 into each stock, for a total investment of $100,000. Just for fun, let's also assume we know ahead of time that one of the stocks in Mr. Jones's portfolio is going to go bankrupt (that is, decline until it becomes worthless) sometime within the next year. (Of course Mr Jones doesn't know this, and we aren't going to tell him, either).

But, since he is a devout Price-Based DCA advocate, his trading rule is that whenever one of his stocks declines 50% in price from his purchase point, he will sell $5,000 worth of one of his better-performing stocks and use the proceeds to buy more shares in the declining stock.
If the issue declines another 50% from his second purchase point, he will sell another $5,000 of one of his other stocks and again add to this declining stock.

Can you guess what will happen to Mr. Jones over the next year as we watch him trade? It should be an agonizing thing to watch because, as you may have figured out by now, Mr. Jones's strategy will over the course of the next year automatically allocate all of his capital to the stock that is to go bankrupt. This is because there are an infinite number of sequential 50% declines that can occur between his initial purchase point and zero. He will lose his entire $100,000 unless he has the good sense at some point to realize what a bloody poor strategy he has.

If you pursue a Price-Based DCA strategy consistently, eventually you will encounter a Waterloo as Mr. Jones is about to. This is because inevitably you will someday get a stock in your portfolio that is bound for the scrap heap. When you do, cut the loss and don't even think about adding to the position! Otherwise, you may find yourself standing in bankruptcy court with Mr. Jones.

When you have a losing position, it means something is starting to go wrong. Never add to a losing position.