Does He Add More?

In investing, says William Miller of Legg Mason, "The lowest average cost wins."  If two investors are both going to sell the same stock at the same price on a given Thursday in 2011, whoever managed to buy it at the lowest price (discounted for date of purchase) will have the better return.

Broadly speaking there are only two ways to achieve the lowest average cost:

1. Initially identifying the lowest-priced opportunities relative to future intrinsic value and putting on a position
2. Given success at 1), adding more to the position when the price goes against you.

The ability to add to a position that is going against you is, in my opinion, one of the supreme tests of a great investor.  In one act you can evaluate not just the quality of the opportunity your investor has identified, but also the strength of his conviction about his own ideas, as well as the ability to act rationally when he might be expected to act emotionally.  In fact, it may be one of the only ways to probe the psychology of your investor. 

So when you're doing your investor due diligence, seek evidence of when he added more in the face of short-term losses, especially big ones.  Written evidence please, as it's much easier to say you do this than to actually do it.

Comments

[nick gogerty]

This theory works well from a potential kelly asset allocation criterion or margin of safety perspective.