When to Buy More

In my previous article I discussed my thought process for "What to Buy, "When to Buy", and "When to Sell". But there's one more question that needs to be answered, and that is "When to Buy More".

As stated in the previous article, you don't want to sell just because the stock price has declined, as long as you followed the "What to Buy" guidelines, and the company fundamentals haven't changed. This past week is a prime example of when not to sell. The market has been extremely volatile, mainly due to the subprime debacle. When the market falls like this many innocent companies get caught in its wake.

Again, as long as you followed the "What to Buy" guidelines, and the company was a good buy when you bought it, it's an even better buy after a decline in price. This is an opportunity to buy more shares at a lower price, thereby lowering your average cost. This technique is known as averaging down, or dollar cost averaging (DCA) if you're making regular periodic purchases. The terms are sometimes interchangeable, but they basically mean the same thing (i.e. you're lowering your average cost).

As Bill Miller, manager of the Legg Mason Value Trust fund, advises, “If you have a chance to lower your average cost you should do so.” Because in the end, “The guy with the lowest average cost wins." Since that philosophy helped him outperform the S&P 500 for 15 consecutive years, I’d say it’s battled tested and worth following.

This is one of the methods I've successfully used in my covered call (CC) strategy to recover from stocks that have declined in price. The added advantage of averaging down a CC position is that you can sell more call options. So, not only do you lower your average cost basis in the stock, you also make it possible to increase the income generated from selling call options.

But again, you must be sure that you followed the "What to Buy" guidelines and that the company fundamentals haven't change before deciding to buy more. You also want to be sure that the new average price is worth the trouble. It's usually not worth buying more if the stock only declined by a small amount. You need a sizable decline to make it worth while. Another consideration is position sizing. I limit all my positions to 5% of total capital, and will usually only average down if the new position remains 5% or less.

So, that's my thought process for "When to Buy More". Again, I hope you found this useful.