Here is a recent question that I got from a reader:

I have a question for you that I don?t think you?ve addressed in your blog. Do you ever double down on something that has dropped significantly beyond portfolio rule VII?s rebalancing requirements and you see no reason to doubt your original thesis? Or do you almost always stick to rule VII? Just curious.

Portfolio rule seven is:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

This rule is meant to control arrogance and encourage patience. ?I learned this lesson the hard way when I was younger, and I would double down on investments that had fallen significantly in value. ?It was never in hope of getting the whole position back to even, but that the incremental money had better odds of succeeding than other potential uses of the money.

Well, that would be true if your thesis is right, against a market that genuinely does not understand. ?It also requires that you have the patience to hold the position through the decline.

When I was younger, I was less cautious, and so by doubling down in situations where I did not do my homework well enough, I lost a decent amount of money. ?If you want to read those stories, they are found in my Learning from the Past series.

Now, since I set up the eight rules, I have doubled down maybe 5-6 times over the last 15 years. ?In other words, I haven’t done it often. ?I?turn a single-weight stock into a double-weight stock if I know:

• The position is utterly safe, it can’t go broke
• The valuation is stupid cheap
• I have a distinct edge in understanding the company, and after significant review I conclude that I can’t lose

Each of those 5-6 times I have made significant money, with no losers. ?You might ask, “Well, why not do that only, and all the time?” ?I would be in cash most of the time, then. ?I make decent money on the rest of my stocks as well on average.

The distinct edge usually falls into the bucket of the market sells off an entire industry, not realizing there are some stocks in the industry that aren’t subject to much of the risk in question. ?It could be as simple as refiners getting sold off when oil prices fall, even though they aren’t affected much by oil prices. ?Or, it could be knowing which insurance companies are safe in the midst of a crisis. ?Regardless, it has to be a big edge, and a big valuation gap, and safe.

The Sense of Rule Seven

Rule Seven has been the rule that has most protected the downside of my portfolio while enhancing the upside. ?The two major reasons for this is that a falling stock triggers a thorough review, and that if I do add to my position, I do so in a moderate and measured way, and not out of any emotion. ?It’s a business, it is not a gamble per se.

As a result I have had very few major losses since implementing the portfolio rules. ?I probably have one more article to add to the “Learning from the Past Series,” and the number of severe losses over the past 15 years is around a?half dozen out of 200+ stocks that I invested in.

Summary

Doubling down is too bold of a strategy, and too prone for abuse. ?It should only be done when the investor has a large edge, cheap valuation, and safety. ?Rule Seven allows for moderate?purchases under ordinary conditions, and leads to risk reductions when position reviews highlight errors. ?If errors are eliminated, Rule Seven will boost returns over time in a modest way, and reduce risk as well.