Averaging down stocks is a strategy that some long term investors use as part of their investment plan. But how do you average down stocks, and how can it benefit you?
We’ll look at what it involves, when it should be used and why, and the advantages and disadvantages of averaging stocks as part of an investment strategy.
What Is An Average Down Strategy?
An average down strategy is when a stockholder buys more of the stock that they already hold, but at a cheaper price. For example, if you bought 100 shares at $20 and then afterwards bought 50 more at $15 this would be averaging down (see also ‘What Is Averaging Down In Stocks?‘).
It is called this because once you have bought the cheaper stock, the average price of your stock is brought down. In this case 150 shares at an average price of just under $79 or $21 less than the original share price.
When a stock price drops there may be different reasons for this, but it is important to understand what is happening with the company or the wider market before deciding to go ahead and purchase more shares regardless of how much the price has gone down.
You should be very familiar with the fundamentals of the company so that you are not tempted to buy more shares in a business that could be declining. Watching what is happening internally as well as the market as a whole will aid your decision.
Investors who are using dollar cost averaging can use this approach as they are focusing on a long term investment strategy and not short term gain.
These types of investors often take a contrary approach to the trend when looking for investment opportunities.
When Should You Use Average Down As A Strategy?
The best time to average down is when the price of a stock drops significantly following the original investment. This allows investors to increase their position in relation to a specific stock, although the average price of their combined shares is now reduced.
It is important to be able to understand the fundamentals of a company whose shares you are averaging down on.
As most investors use this strategy as part of a long term investment plan, being aware of the market in general and the particular stock is absolutely vital.
Without adequate knowledge or insight, purchasing stocks at a lower price than you previously paid could mean you are just left holding more shares in a company that is declining. The benefit of averaging down is only realized if the stock rebounds.
This strategy involves taking a contrarian approach to current trends in the stock market and prevailing thinking regarding investment.
This is why it suits those who are looking at a long term investment horizon, but it should form part of a fuller investing strategy.
Only after careful consideration should an inexperienced investor use averaging down as a strategy. Without insight into why a stock price is falling and what the longer term implications could be, averaging down may only lead to less valuable shares.
Why Would You Average Down On Stock?
Many investors use averaging down as part of their wealth accumulation plan, and this is why it is used as part of a long term strategy. Those who engage in dollar cost averaging use averaging down to add to their portfolio.
Dollar cost averaging involves regular investing in the stock market regardless of whether prices are going up or down. The aim is to reap long term average gains rather than making a quick profit.
An example of this would be a company that is experiencing some restructuring. This could make the market nervous and stock may fall temporarily.
Someone with deeper knowledge would look closer and see that the company is fundamentally sound and average down.
As long as you are confident that the stock will rebound, there is no reason not to add to your shares and benefit in the long run.
Of course, it is not always possible to predict what will happen, and even the most experienced investors get it wrong occasionally.
Loss mitigation is another reason for averaging down. If you buy 50 shares at $100 each and the price then drops to $75 that is a 25% loss and the stock would need to increase by 33% from $75 to $100 to start making a profit.
By averaging down and buying another 50 shares at $75 the price only needs to go up 25% for you to begin to profit.
Advantages & Disadvantages Of Averaging Down
In order to make the strategy of averaging down work for you, it is necessary to look at all its advantages and disadvantages.
The main advantage of this approach is that you end up with more of the stock that you want to own at a discounted price. This has the potential to make you a profit in the long term. Recent price movements should not be your sole motivation or indicator of performance.
If the stock then goes on to perform well, you will have made a sound investment and a good profit for less outlay than you otherwise would have.
For long term investment goals, averaging down can provide good returns. However, you need to be able to tell the difference between short term downturns in a company’s stock and a sustained decline.
Experience and good research can help, but nothing is certain.
One of the disadvantages of averaging down is that you may end up with additional shares in a company that is experiencing more than a temporary slump (see also ‘What Is A Pullback In Stocks?‘). If the stock fails to recover, you will be working at a loss.
Projecting the trajectory of stock is tricky and not foolproof.
So, by buying more of a stock that you already own, you are reducing the average price per share. If the price rebounds, you will make a profit on all the shares. It is a risk, but with some experience and research it can pay dividends.