It’s one of the biggest unknowns in investing: How long should one hold onto a stock? And when is it a good time to buy? The answer varies from investor to investor, based on a combination of research, experience, and intuition. As investors are building their investment portfolio, one strategy they sometimes employ is “averaging down stock.”
Averaging down stock means that an investor purchases more of a certain stock that they already own, after that stock has lost value. By purchasing more of the same stock at a now lower price, the investor brings down the average price for those stocks in their portfolio. We’ll take a look at the pros and cons of averaging down, and when it might be a good time to implement this investment strategy.
What Is Averaging Down Stock?
Consider this example: Imagine an investor who purchased 100 shares of stock for $70 per share. Then, the value of the stock falls to $60 per share.
Interested in averaging down, the investor purchases another 100 shares of the same stock at $60 per share. Now, the investor owns 200 shares: half were purchased at a price of $70 per share, and half were purchased at $60 per share. This creates an average purchase price of $65 per share. The investor has effectively averaged down by lowering the average purchase price of their stock.
As with any strategy, there’s risk in averaging down. If, after averaging down, the price of the stock goes up, then the investor’s decision to buy more of that stock at a lower price would have been a good one. If the stock continues its downward price trajectory, it would mean the investor just doubled down on a losing investment.
Why Average Down on Stock
Investors who have a long-term strategy or who focus on a value investing strategy may be attracted to averaging down. Value investing is a style of investing that focuses on finding stocks that are trading at a “good value”—in other words, they are currently underpriced. By averaging down, an investor buys more of a stock that they like, at a lower price. For some investors, it’s a way to get more money into the market.
Some investors turn to this strategy to help dig out of the very hole that the temporarily lower price has dug them into. That’s because a stock that has lost value has to grow proportionally more than it fell in order to get back to where it started. Again, an example will help:
A stock that was trading at $100 falls by 20%, so it’s now worth $80. But if the stock then rises by 20%, it would have only increased by $16. It actually needs to increase by 25% in order to get back to $100. The climb up is steeper than the fall, because the stock is starting at a lower base.
However, if an investor purchases additional shares of that stock at the lower price point, then that stock’s average path to profit is shortened. Because with the new stocks, profit will take place as soon as they’ve moved into the green.
Pros and Cons of Averaging Down
In some scenarios, the averaging down strategy could work successfully. In other scenarios, it might not work at all. There’s no real way to know how it will work at any given time without knowing the future of returns for that individual stock. And accurately predicting the future of a stock is a tall task even for a professional with access to all existing research, let alone an independent investor.
Still, there are ways to consider the upsides and downsides of averaging down on stocks.
Pros of Averaging Down
The primary benefit to averaging down is that an investor can buy more of a stock that they want to own anyway, at a better price than they paid previously. It should as much be a decision about the desire to own a stock over the long-term as it is about the recent price movement. After all, recent price changes are only one part of a stock’s analysis.
If the investor feels committed to the company’s growth and believes that its stock will continue to do well over longer periods, it could validate the purchase. And, if the stock in question ultimately turns positive and enjoys solid growth over time, then the strategy will have been a success.
Another benefit is that this strategy may encourage an investor to commit more money towards their investment portfolio, which could be a positive factor in and of itself. Doing the work of investing on a regular basis is often as important as any other piece of strategy.
Finally, the averaging down strategy may also tap into an investor’s “buy low, sell high” mentality. As with any investment, the goal is to purchase something that will either create an income stream, or that can be sold later at a higher price. Therefore, investors should prefer to pay a lower price, as opposed to a higher one.
Cons of Averaging Down
The averaging down strategy requires an investor buy a stock that is, at the moment, losing value. And it is always possible that this fall is not temporary—and is actually the beginning of a larger decline in the company and/or its stock price. In this scenario, an investor who averages down may have just increased their holding in a losing investment.
Price change alone should not be an investor’s only indication to buy more of any stock. An investor with plans to average down should research the cause of the decline before buying—and even with careful research, projecting the trajectory of a stock can be difficult. That’s because price changes in the short-term can be driven by investor demand or sentiment, which is notoriously difficult to predict. It would require knowing what millions of investors across the globe—including institutional investors—are going to want tomorrow, next month, or even in the next few years.
This is all connected to the reality that picking individual stocks, in general, is difficult. In fact, the majority of individual stocks do not outperform the index average. Add in the notorious difficulty of knowing when to buy and when to sell stocks, and it could be a recipe for heartache.
For investors interested in averaging down, it makes sense to do as much research on the company and the stock as possible. It’s not enough to simply go with intuition and expect that stock prices will rise after you buy low.
Furthermore, it’s a common misconception that an investor must buy individual stocks in order to be successful. In reality, there may be easier ways to invest that could be more successful over the long-term, such as a buy-and-hold index fund strategy.
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