Adding to a Loser Definition and Example

What Is Adding to a Loser?

Adding to a loser is a term that refers to an instance in which a trader or investor increases their position in an asset when its price is moving in the opposite direction of their original purchase. They are adding more funds, or increasing their position size, in a losing position.

Understanding Adding to a Loser

Adding to a loser refers to situations in which an individual invests more in an asset, even though that asset is performing opposite to the investor’s wishes. There can be both pros and cons to adding to a loser.

Some investment advisors may encourage the practice, calling it « averaging down, » and this may be acceptable for a long-term investor with a long time horizon for their investments and with a bullish view about the asset in the long term. Adding to a losing trade, at a better price than the original entry, will bring down the average entry price. If the price eventually reverses, the gain may be bigger than it would have been if only the initial position was taken.

Adding to a loser should only be done if it is part of an investment plan or trading plan. It should never be done simply to avoid having to take a loss. Losses are a part of trading and investing, and sometimes it is better to get out and take a small loss instead of doubling down and risking a big loss.

It is possible that an asset’s price keeps moving in the wrong direction relative to the investor’s wishes. In this case, the investor faces increasing losses by adding to the losing position.

Why Traders Add to Losing Positions

There are several reasons an investor may add to losing positions. The most common one is an emotional response in which an investor might add to a losing position instead of closing it because they get emotionally attached to the asset and have a hard time accepting that it was a bad investment.

Also, asset prices are always fluctuating, and it is hard to pinpoint the perfect entry. If a stock declines initially after purchase, an investor may feel a compulsion to buy more at the lower price, feeling regret for having bought at a higher price. They want to « take advantage » of the lower price.

In all cases, once an investment moves in the wrong direction, it is important to reevaluate the reason for having the position. Is still worth holding? Is adding more funds a prudent play? Should it be sold? Professional traders and investors lay out the answers to these questions in advance. They have strategies which include buy and sell rules laid out in their trading plan.

Adding to a loser may be part of such a plan. For example, an investor may buy additional stock each month as part of their portfolio contributions. They do this regardless of the price of the stocks. In this case, they may not only be adding to losers, but also adding to winners or pyramiding.

Psychology of Adding to a Loser

As mentioned above, there may be a mental aspect to adding to a loser. For a variety of reasons, an investor may choose to double-down their position on an investment they have yet to be successful for. Below are variety of psychological elements that may be playing a factor when adding to a loser.

Loss Aversion

Loss aversion refers to the tendency of individuals to feel the pain of losses more acutely than the pleasure of gains. This bias can lead investors to hold on to losing investments in the hope that they will eventually turn around and recover their losses. For some investors, the fear of regret and the psychological impact of accepting a loss often outweigh the rational assessment of the investment’s potential.

Anchoring Bias

Anchoring bias occurs when individuals heavily rely on an initial reference point such as the purchase price of an investment. In the case of adding to a loser, investors may become anchored to the original purchase price and continue to invest in a declining asset, believing that it will eventually return to its initial value and even higher. This bias can prevent them from objectively evaluating the investment’s current prospects and making rational decisions as they are too tied up in the past.

Overconfidence Bias

Overconfidence bias manifests when individuals overestimate their abilities and knowledge. This leads them to believe they can predict market movements or turn around a losing investment. This bias can contribute to an unwarranted optimism and a persistence in adding to a losing investment.

Confirmation Bias

Confirmation bias is the tendency to seek information that supports existing beliefs while disregarding or downplaying contradictory evidence. In the context of investing, individuals may selectively focus on positive news or opinions that align with their conviction. Also in this context, they may choose to ignore or discount negative information. This bias reinforces their belief in the investment’s potential and can lead to a continued commitment to the losing position even when a majority of the evidence suggests otherwise.

Herd Mentality

Herd mentality refers to the inclination of individuals to follow the actions of the majority. When other investors are adding to a losing investment, individuals may feel a sense of safety and reassurance in joining the crowd. This behavior stems from the belief that the collective action of many implies a higher likelihood of a positive outcome.

Sunk Cost Fallacy

Last, the sunk cost fallacy is the tendency to continue investing in a losing position due to the resources already committed, regardless of the potential for future gains. Investors may be reluctant to accept a loss and cut their losses because they perceive it as a waste of the time, effort, and money they have already invested. In reality, the decision should be made looking forward, not back. This fallacy prevents individuals from making objective decisions based on the current and future prospects of the investment while discounting their prior actions.

Tips To Avoid Adding to a Loser

Though future price fluctuations can’t be predicted with certainty, there are steps investors can take to become more diligent and disciplined when making investment decisions. This may include a specific list of rules related to increasing a position in an already struggling position.

Before investing, thoroughly research the investment opportunity including the company, industry trends, financials, and potential risks. This knowledge will help you make informed decisions and avoid investing in weak or underperforming assets. You should also determine your risk tolerance, time horizon, and desired returns, as having a well-defined investment strategy will help you avoid impulsive decisions that may add to losing investments.

In many contexts, diversification is key to minimizing risk. Allocate your investments across different asset classes, industries, and geographical regions. Adding to a loser is not conducive to this strategy, as overexposing your portfolio to a single asset or sector can significantly increase the risk of adding to a loser. Stick to your investment plan and avoid emotional reactions to market fluctuations.

It’s important you stay actively involved in monitoring your investments. Consider using stop loss orders to cut your ties should an investment hit a specific target price. Implement risk management strategies such as position sizing to limit exposure. It’s also important to stay engaged as new developments with companies you own may change the disposition you have of the company’s outlook.

Benefits of Adding to a Loser

In the context of the last few sections, it’s important to realize that adding to a loser may still prove to be the right move. In certain situations, adding to a struggling position may prove to have been the correct move.

Investors can lower their average cost basis by adding to a loser at a reduced price. In the end, this can improve the overall return on the investment. This can also increase the potential for future profits, as investors often take a long-term value approach when evaluating a loser for further investment.

Capitalizing on market inefficiencies can also create opportunities, such as when a stock or asset experiences a decline due to short-term market sentiment or external factors. By capitalizing on these inefficiencies, investors can potentially benefit from a subsequent correction or rebound. In these contexts, the investor putting money into a loser may be more rational than emotionally-driven traders who are impulsively trading on short-term sentiment.

Strategic portfolio allocation can also be used to add to a loser. If an investor has a long-term investment horizon and a diversified portfolio, they may allocate a small portion of their capital to high-risk investments, including some losers, to recognize the potential for higher returns in riskier assets. Depending on overall portfolio movement, the investor may want to reallocate funds into riskier assets to maintain a specific portfolio allocation. Though this position may be taking on more risk due to the nature of the struggling investment, it may prove to lower risk in other contexts due to the nature of a more diversified portfolio.

Example of Adding to a Loser

Assume an investor noticed the prior uptrend and waited for a pullback, buying 100 shares of stock at $32 in October. The investor views this as a long-term hold. The trade costs $3,200.

By January, the security is now trading at $16. The value of the position is half of the original value of the position, as the position is now worth $1,600. The investor decides the stock is a bargain at $16, and so they increase their position, buying another 100 shares at $16. This costs an additional $1,600.

As of January, the investor now has 200 shares of stock valued at $4,800. The average price is now $24. If the stock prices rallies above $24, the investor will be in the money even though they originally bought at $32. Their risk has increased, though. Before, they were risking $3,200, now they are risking $4,800 ($3,200 + $1,600). If the stock continues to decline below $16 they are losing on 200 shares, not just 100.

By March, the stock is now trading below $7. The investor’s position is now worth $1,400 ($7 x 200 shares). So far the investor has lost 71% of their investment (($4,800 – $1,400) / $4,800). In this case, even if the stock doubles from $7 (to $14), the investor would still be underwater on their purchase at $16, and way underwater on their purchase at $32.

In this example, the investor could have walked away from the stock after the initial price drop. Instead, they remained confident in the company and felt the security was undervalued. Because that investment decision did not materialize, the investor unfortunately added to a loser and continued to lose thereafter.

The Bottom Line

Adding to a loser in investing refers to the behavior of investing additional funds into an investment that is already performing poorly or experiencing losses. It often stems from psychological biases such as loss aversion, overconfidence, and the fear of missing out. Investors may cling to losing positions, hoping for a rebound or reluctant to accept losses. However, adding to a loser can amplify financial losses, hinder portfolio diversification, and impede long-term investment growth.