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What Is Averaging Down?
Averaging down refers to a strategy of buying more shares of a stock you already own after that stock has lost value — effectively buying the same stock, but at a discount. In other words, it’s a way of lowering the average cost of a stock you already own. By purchasing more of the same stock at a lower price, the investor brings down the average price (or cost basis) for all the shares of that stock in their portfolio.
So if you buy 100 shares at one price, and the price drops 10%, for example, and you decide to buy 100 more shares at the lower price, the average cost of all 200 shares is now lower.
It’s similar to dollar-cost averaging, where you invest the same amount of money in the same securities at steady intervals, regardless of whether the prices are rising or falling.
The question is, Does averaging down stock make sense? How might averaging down stocks benefit an investor, or expose them to more risk? Let’s take a closer look.
Example of Averaging Down
Consider this example: Imagine you’ve purchased 100 shares of stock for $70 per share ($7,000 total). Then, the value of the stock falls to $35 per share, a 50% drop.
To average down, you’d purchase 100 shares of the same stock at $35 per share ($3,500). Now, you’d own 200 shares for a total investment of $10,500. This creates an average purchase price of $52.50 per share.
If the stock price jumps to $80 per share, your position would be worth $16,000, a $5,500 gain on your initial investment of $10,500. In this case, averaging down helped boost your average return. If you’d simply bought 200 shares at the initial price of $70 ($14,000), you’d only see a gain of $2,000.
As with any strategy, there’s risk in averaging down. If, after averaging down, the price of the stock goes up, then your 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 you just doubled down on a losing investment.
Why Average Down on Stock
Averaging down stocks can work for some investors if the markets work in their favor — or if they are experienced enough to understand when a price decline might be temporary or part of a longer downturn.
1. Value Investing
Value investing is a style of investing that focuses on finding stocks that are trading at a “good value” — in other words, value stocks are typically underpriced. By averaging down, an investor buys more of a stock that they like, at a discount.
But in some cases, a stock may appear undervalued when it’s not. This can lead investors who may not understand how to value stocks into something called a value trap. A value trap is when a company has been trading at low valuation metrics (e.g. the P/E ratio or price-to-book value) for some time. While it may seem like a bargain, if it’s not a true value proposition the price is likely to decline further.
2. Dollar-Cost Averaging
For some investors, averaging down can be a way to get more money into the market. This is similar philosophy to dollar-cost averaging, as noted above, where the idea is to invest steadily regardless of whether the market is down or up, to reap the long-term average gains.
3. Loss Mitigation
Some investors turn to this strategy to help dig out of the very hole that the lower price has put 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:
Let’s say you purchase 100 shares at $75 per share, and the stock drops to $50, that’s a 33% loss. In order to regain that lost value, however, the stock needs to increase by 50% (from $50 to $75) before you can see a profit.
Averaging down can change the math here. If the stock drops to $50 and you buy another 100 shares, the price only needs to increase by 25% to $62.50 for the position to be profitable.
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Pros and Cons of Averaging Down
As you can see, averaging down stocks is not a black-and-white strategy; it requires some skill and the ability to weigh the advantages and disadvantages of each situation.
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 — with the potential for substantial gains.
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, that could justify 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.
Cons of Averaging Down
The averaging down strategy requires an investor to 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.
Another potential downside is that the averaging down strategy adds to one particular position, and therefore can affect your asset allocation. It’s always wise to consider the implications of any shift in your portfolio’s allocation.
Tips for Averaging Down on Stock
If you are going to average down on a stock you own, be sure to take a few preparatory steps.
• Have an exit strategy. While it may be to your benefit to buy the dip, you want to set a limit should the price continue to fall.
• Do your research. In order to understand whether a stock’s price drop is really an opportunity, you may need to understand more about the company’s fundamentals.
• Keep an eye on the market. Market conditions can impact stock price as well, so it’s wise to know what factors are at play here.
To recap: What is averaging down in stocks? Simply put, averaging down is a strategy where an investor buys more of a stock they already own after the stock has lost value. The idea is that by buying a stock you own (and like) at a discount, you lower the average purchase price of your position as a whole, and set yourself up for substantial gains if the price should increase. Of course, the fly in the ointment here is that it can be quite tricky to predict whether a stock price has simply taken a dip or is on a downward trajectory.
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