Averaging down is an investment strategy that involves buying more shares of a stock when its price declines, which lowers the average cost per share. It's also known as "dollar cost averaging."
For example, suppose you buy 100 shares at $50 per share for a total of $5,000. Then the stock drops to $40 per share. You then buy another 100 shares at $40 per share for a total of $4,000. You now own 200 shares and spent a total of $9,000. The average price per share that you own is now $45.
If the stock rebounds to $60 per share, then averaging down would have been an effective strategy for seeing returns on your investment. However, if the stock continues to fall in price, then you may lose money. At that point, you may have to decide whether to keep averaging down or bail out and take the loss.
Here's what to consider if you're thinking of averaging down on your stock market investments.
Is Averaging Down an Effective Strategy?
Plain and simple, the answer to this question is that it depends. Additionally, investment professionals tend to have differing opinions on the effectiveness of averaging down.
Investors who are taking a long-term and contrarian approach to investing tend to favor the averaging-down approach.
This is not a strategy to employ lightly. If there is a heavy volume of selling against a company, then you'd be taking a contrarian approach to investing, and going against the trend. Going against what the majority is doing, and buying shares when others are selling, can sometimes prove profitable, but it can also mean that you're missing the risks that are prompting others to sell.
But if you're investing in a company, as opposed to just a stock, then you may have a better sense of 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 of time.
When It Might Not Pay to Average Down
Investors who make short-term investments and are investing simply 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 and investing short-term is to cut your losses at a certain amount.
The time to cut your losses with averaging down is different for every investor, and it depends on your risk tolerance.
For example, you could aim to limit your losses to 5% or maybe 10% of your investment. So if you owned 100 shares of a stock at an average of $100 per share, you might limit your losses to 10% and sell when the share price drops to $90. That is known as a "target profit/loss ratio exit strategy." It may help prevent you from losing too much after averaging down.
The Bottom Line
If you're playing a short-term stock game, then averaging down probably doesn't make any sense. Consider your risk tolerance and take a small loss before it becomes a big loss. Then move on to your next investment.
If you're more focused on long-term investments in companies, then averaging down may make sense. It allows you to accumulate more shares at a lower price—as long as you are convinced the company is fundamentally sound. You may end up owning more shares at a lower average price, and potentially turning a pretty profit.
Frequently Asked Questions (FAQs)
Do you lose money when you average down stocks?
It's quite possible to lose money when you average down. If you keep purchasing shares of a stock, and its price continues to fall, you will lose money on your investment. It's a risky strategy—one that you should only employ if you have a good understanding of the company involved and strong confidence that it will bounce back.
How do you calculate a break-even point when averaging down?
There's no way to tell a set break-even point when you are averaging down. The strategy is only effective if the stock eventually rebounds, and the price goes back up. If it continues to fall, you'll lose money, and it's just a question of when you need to cut your losses.
Is averaging down a way to cover up a stock purchase mistake?
It can be an investing mistake to average down just to make your purchase look better. Traders have been known to use the average-down method to make the initial stock purchase look good. If the stock continues to decline, it is harder to cover up the fact that you purchased stock that has gone down in price.