Averaging Down Stocks as an Investment Strategy
Averaging down is an investment strategy that involves buying more of a stock after its price declines, which lowers its average cost. A simple example: Let's say you buy 500 shares at $50 per share, but the stock drops to $46 per share. You then buy another 500 shares at $46 per share, which lowers your average price to $48 per share.
If the stock rebounds to $60 per share, then averaging down can potentially be seen as an effective strategy. However, if the stock continues falling, then it may not be. You may have to decide to keep averaging down or bail out and take a loss.
Is Averaging Down an Effective Strategy?
Whether or not averaging down is a strategy you should pursue depends on a few factors, and investment professionals tend to have differing opinions on its effectiveness.
Investors who are taking a long-term and contrarian approach to investing in companies tend to favor the averaging down approach.
This is not a strategy you should employ lightly. If there is a heavy volume of selling against the company, then you'd be taking a contrarian approach to investing, or going against the trend. Swimming against the current can sometimes prove profitable, but it can also sweep you over the waterfall.
But you're investing in a company, as opposed to just a stock, then you may have a better senses whether a drop in the stock's price is temporary or a sign of trouble, based on past performance and the current state of the company.
If you truly believe in the company, then averaging down may make sense if you want to increase your holdings in the company. Accumulating more stock at a lower price makes sense if you plan to hold it for a long period.
When It Doesn't Pay to Average Down
Investors who make short-term investments and are investing in stock rather than companies tend not to favor averaging down. They look for buy and sell signals based on a number of indicators that follow trends rather than going against them.
If your goal is to make money on the trade and you have no real interest in the underlying company other than how it might be affected by market, news or economic changes, then averaging down is likely not the right strategy for you. In most cases, that's because you don't know enough about the underlying company to determine if a drop in price is temporary or a reflection of a serious problem.
A typical course of action when investing in a stock (as opposed to a company) and investing short-term is to cut your losses at no more than 7%. When the stock drops that much, sell and move on to the next deal.
If you're playing a short-term stock game, then averaging down probably doesn't make any sense. Take a small loss before it becomes a big loss and move on to the next trade. If you make long-term investments in companies, then averaging down may make sense if you want to accumulate more shares and are convinced the company is fundamentally sound.