Averaging down is an investment strategy that is used among investors in stocks.
Averaging down involves investing more money in a financial asset if it lowers in value and price significantly after the investment is initially made.
If this happens, it can bring down the average cost of the asset which won’t lead to great returns.
his situation may result in an investor having a bigger share of an investment that is losing money.
However, there is a big difference in opinion surrounding the validity and viability of this strategy.
Advantages Of Averaging Down
Averaging down is a very cost-effective approach to the accumulation of stocks and wealth. It is commonly used and favored by certain investors who have a long term investment plan.
The approach of averaging down also has a great style of investing that goes against the investment trend that is occurring.
One big advantage of averaging down is the fact that an investor can reduce the average cost of stock value a lot.
This is a great thing if the stock turns around, meaning that you will earn more money from the stock.
It ensures a lower break even point where you don’t need the stock to rise too much in order to make money from it.
You will, therefore experience higher gains compared to the gains you would experience if you had never averaged down.
Disadvantages Of Averaging Down
Averaging down only works if the stock rebounds at some point. This will happen because of the effect of magnifying gains.
Sometimes, when stock averages down, it will then continue to decline. When this happens, losses are magnified.
When stock continues to decline, this may mean that you will end up losing lots of money in these stocks.
In this case, an investor may regret their decision to average down over leaving the position.
This is why it is very important to consider all the risks of averaging down. You should assess all the risks of the stock being averaged down.
It is much easier said than done, however, as there have been a lot of situations where it would have been impossible to accurately assess the risk of stocks before they failed.
Another disadvantage of choosing to average down is that it might mean there is a higher weighting of a certain stock or industry sector.
For instance, it may result in exposure to bank stocks to a higher degree than the investor desired.
How To Successfully Execute Averaging Down
There have been many cases where investors have successfully completed the averaging down strategy.
It is a very viable strategy and, when it is done correctly, it can work out very well for investors.
There are a few things you can do to make sure that you execute the averaging down strategy accurately.
- Restrict Averaging Down
Averaging down is a very risky strategy and it should only be done for certain stocks rather than for every stock that an investor has on their books.
It works best when it is restricted to high-quality stocks. This is because, in these cases, the risk of the company going bankrupt is very low. These are known as blue-chip stocks.
Blue chip stocks are characterized by things such as a long-term track record, very low or no debt, a stable business and reliable cash flow.
These are the best candidates for averaging down.
- Assess The Fundamentals Of A Company
Before you choose to average down, the fundamentals of the company should be considered.
The investor should consider whether there is a reason for the decline in stock (see also our article on pullback), whether it is a temporary case or it is a longer-term problem.
You should make sure that you consider the company’s position in the competitive market and their long-term stability before you consider averaging down.
You must make sure that you consider the timing of when you choose to average down.
At times when there is panic liquidation occurring, you should make sure that you consider this.
This can mean that high-quality stocks are lower in the price for a short period.
When Is It A Bad Idea To Average Down In Stocks?
If you are looking at a stock that has been on a downtrend for a long period of time, it is not the best idea to average down.
This is because it is very difficult to judge when this stock will hit the bottom.
If the stock has been declining for a while and it has shown no signs of improvement, chances are that it will continue to fall.
Averaging down is also a bad idea when you have leverage. This is because you may end up having to deposit more money or withdraw from the stock and make a loss.
Averaging down is also not a great idea for short-term traders. This is because if you are trading over the period of a day, then the stock may not increase in price within the time that you need it to. Stock prices often drop for longer than 1 day.
How Do You Average Down In Stocks?
If you have chosen to average down on stocks, follow these steps below:
- First you should consider whether it is a good time to invest in stock. You should consider buying stocks when they are low in price.
- If you find that the stocks have gone up after you purchase them, then you have likely avoided the downfalls that come with averaging down.
- You should then ensure that you monitor the performance of any investments that you make in order to stay on top of them.
Averaging down is a very realistic and viable strategy for investors to use.
However, when you are choosing to average down, investors must make sure that they are considering their options and assessing their chances of success.
If you choose to average down on blue-chip stocks, then this will give investors a higher chance of success.