Most investors know what it feels like to buy a share that drops sharply in price shortly afterward. But some try to take advantage of such market falls. We explain what ‘averaging down’ is.
Averaging down is the act of contributing to your investment accounts on a regular and continuous basis. Averaging down stocks is one of the long-term investors’ most common investing approaches, and it allows them to lower their average price per share and take advantage of market volatility. But when should you do it? How do average down stocks like professional investors?
Amid the chaos of changing economic information and company news, committing to a trading strategy helps investors to remain focused. Averaging down is simple strategy investors use for this purpose. When investors average down, they add shares of an existing position at a lower cost basis. The underlying theory is that purchasing more shares at a lower cost reduces their average price.
What is the average down in stocks?
The investment strategy of averaging down entails acquiring more shares of a previously made investment after the price has declined. This second purchase results in a drop in the average price at which the investor acquired the stock. It may be compared to averaging up.
For instance, an investor who purchased 100 shares of a stock at $50 per share may purchase an additional 100 shares if the firm’s price dropped to $40 per share, bringing their average price (or cost basis) down to $45 per share. Some financial counselors urge investors to use dollar-cost averaging (DCA) or averaging down while purchasing and holding stocks or mutual funds.
The primary concept behind the strategy of averaging down is that when prices increase, they do not need to climb as much for an investor’s position to begin generating a profit.
Consider that if an investor acquired 100 shares of stock at $60 per share and the price plummeted to $40 per share, the investor would have to wait for the company’s price to recover 33 percent. However, based on the current price of $40, that is not a 33 percent increase. Now, the stock must increase by fifty percent for the position to be profitable (from 40 to 60).
This mathematical truth is addressed by averaging down. If the investor acquires 100 extra shares of stock at $40 per share, the price only has to increase to $50 (a 25 percent increase) for the position to be profitable. Once the stock reaches $60, the investor will begin to realize a return of 16% should the stock recover to its initial price and then continue to rise.
Although averaging down has certain elements of a strategy, it is insufficient. Averaging down is a behavior that stems from a mindset rather than a smart financial strategy. Averaging down allows an investor to overcome cognitive or emotional biases and functions more as a safety net than a sensible policy.
Why average down on stock?
1. Value Investing
Value investing is an investing strategy that focuses on locating stocks that are selling at a “good value” – that is, value stocks are often underpriced. By averaging down, an investor purchases additional shares of a stock at a discount.
In other instances, though, a stock may seem to be inexpensive when it is not. This might lead investors who lack an understanding of how to evaluate stocks into a value trap. A value trap occurs when a firm trades at low valuation measures (such as the P/E ratio or price-to-book value) over an extended period of time. If it is not a real value offer, the price will likely decline further, despite the fact that it may seem a good deal.
2. Dollar-Cost Averaging
Averaging down might be a method for some investors to invest more money in the market. This is similar to dollar-cost averaging, as described above, in which the goal is to invest consistently regardless of market conditions to achieve long-term average returns.
3. Loss Mitigation
Some investors use this strategy to assist them in climbing out of the hole that the reduced price has created. In order to return to its initial value, a stock that has lost value must increase proportionately more than it decreased. Again, an illustration is helpful:
Suppose you purchase 100 shares for $75 per share, and the price of the stock falls to $50, representing a 33 percent loss. Before realizing a profit, the stock must increase by 50 percent (from $50 to $75) to recover its lost value.
Averaging down may alter the math in this situation. If the stock falls to $50 and you buy an additional 100 shares, the price just needs to increase 25% to $62.50 for the investment to be profitable.
The benefits of averaging down
The primary benefit of averaging down is that an investor may significantly reduce the average cost of a stock portfolio. Assuming the stock reverses course, this provides a lower breakeven point for the stock position and greater dollar-based winnings (compared to the gains if the position was not averaged down).
The investor may reduce the position’s breakeven point (or average price) to $45 by averaging down via the purchase of an additional 100 shares at $40 in addition to the 100 shares at $50:
100 shares x $(45-50) = -$500
100 shares x $(45-40) = $500
$500 + (-$500) = $0
In six months, if the stock trades at $49, the investor stands to earn $800 (despite the fact that the stock is still trading under the original entry price of $50):
100 shares x $(49-50) = -$100
100 shares x $(49-40) = $900
$900 + (-$100) = $800
If this trader had not averaged down when the stock price dropped to $40, the potential gain on the position (when the stock price is $55) would be just $500.
100 shares x $(55-50) = $500
100 shares x $(55-40) = $1500
$500 + $1500 = $2,000
If this investor had not averaged down when the stock decreased to $40, the potential gain on the position (when the stock is at $55) would amount to only $500.
Disadvantages of averaging down
Because it has the effect of amplifying gains, averaging down is only successful if the stock finally recovers. Nonetheless, losses are exacerbated if the stock continues to decline. In situations when a stock continues to decline, an investor may regret averaging down instead of selling the stock or abandoning the investment.
Consequently, it is essential for investors to accurately evaluate the risk profile of the stock being averaged down. This is, however, easier said than done, and it gets much more challenging during stock market dips and bad markets. For instance, during the 2008 financial crisis, Fannie Mae, Freddie Mac, AIG, and Lehman Brothers lost most of their market value in a couple of months. Even the most experienced investor would have had a tough time appropriately assessing the danger of these stocks prior to their decline.
A further possible downside of averaging down is that it may result in a greater proportion of a stock or industrial sector within a portfolio. Consider, for instance, the scenario of an investor who had a 25 percent position in U.S. bank stocks at the beginning of 2008. If the traders had averaged down their bank holdings following the steep decrease in the majority of bank stocks during that year, these stocks might have comprised 35% of the investor’s overall portfolio. This percentage shows a greater exposure to bank stocks than was initially planned by the investor.
Is averaging down an effective strategy?
The straightforward answer to this question is that it depends. In addition, investing experts tend to have divergent views about the efficacy of averaging down.
Long-term contrarian investors advocate averaging down investing.
This strategy should not be used carelessly. If there is a large amount of selling against a firm, you would adopt a contrarian investment strategy and go against the trend. Contrary to the majority, purchasing shares while others are selling might be advantageous, but it can also mean overlooking the risks that are causing others to sell.
However, invest in a business as opposed to merely a stock. You may have a better idea of whether a stock price decline is transitory or a hint of problems based on the firm’s historical performance and present condition.
If you actually trust in the firm and want to increase your ownership, then averaging down may make sense. If you want to own the stock for an extended length of time, it makes sense to buy additional shares at a price.
How to use averaging down to invest
If you are satisfied with the risks associated with an average-down strategy, the following advice will help you implement it in your portfolio.
Do your homework. Before trying to average down, it is crucial to examine a company’s fundamentals to determine its financial stability. This may assist in differentiating between short-term and long-term price declines.
Examine the market situation. Consider the market as a whole in addition to internal factors that may be driving a company’s stock price to plummet. Assess the likelihood that present price patterns will continue by analyzing the market cycle and any factors that may be driving volatility.
Set limitations. Choosing an exit point at which you will sell your investment or a point at which you will no longer purchase further shares is one strategy to limit loss possibilities while averaging down. Such restrictions may prevent you from investing additional money in a stock that may be losing value.
When might an investor employ this strategy?
Averaging down is often most beneficial for longer-term investing plans. This is due to the long-term investment horizon of transactions and mostly applies to stock index funds, which tend to increase over time, which may not hold true for any specific stock.
Occasionally, passive investing might also benefit from averaging down. In this situation, investors would often purchase index exchange-traded funds (ETFs) as the price falls. Effective because the investor has a long-term perspective and will buy at predetermined intervals.
Short-term traders may also choose to average down, but this is riskier since there is no way to predict if the stock will rebound. This is precisely why a trader could want to utilize this strategy: They have previously acquired the stock, which is now selling at a discount, but they continue to believe it will rise.
Another reason traders use this strategy is to average down their stock holdings before selling to break even. As additional shares are acquired at a discount, the breakeven cost decreases. This is also a dangerous wager since the transaction no longer has the potential to generate a profit (if sold at breakeven). There is also a substantial danger that the price will continue to fall.
What are the alternatives to this strategy?
There are alternatives to arithmetic mean:
Consider closing lost positions at specified levels and re-entering the market when circumstances improve, or the price begins to rise again.
You may consider numerous purchases. For example, suppose you want to buy a stock for around £50. If you want to purchase one-third of the position for around £50 and it falls to £40, you may purchase another one-third, and if it falls further, you could purchase the remaining one-third. In either situation, your average price would be close to or more than what you want.
Consider investing in a diverse array of stocks and ETFs. Determine how much you will put in each and stop there. People who average down are often over-invested in a particular stock and have a narrow concentration. Avoid this problem by diversifying your assets.
A buy-the-dip strategy is predicated on the premise that prices will decline by a specific amount, and the investor will make a purchase at that time. This is distinct from averaging down, which is sometimes done arbitrarily without statistical evidence to support the purchasing.
The bottom line
In terms of stocks, what is averaging down? A simple strategy of averaging down is when an investor purchases more shares of a stock they already own after the stock has lost value. By purchasing a stock you already own (and enjoy) at a bargain, you may increase the average purchase price of your whole investment and position yourself for big returns if the price rises. Obviously, the fly in the ointment is that it may be difficult to determine if a stock price has just taken a dip or is on a downward track. An effective investment strategy for stocks, mutual funds, and exchange-traded funds is averaging down. However, investors must be cautious when choosing which assets to average down. The strategy should be limited to blue-chip stocks that meet severe selection criteria, such as a long track record, low debt levels, and good cash flow.
Do you incur losses while averaging down stocks?
When averaging down, it is extremely probable to lose money. If you continue to purchase shares of stock while its price continues to decline, you will incur a loss. It is a dangerous strategy that you should only utilize if you have a thorough grasp of the firm in question and great faith in its ability to recover.
Is it prudent to average down on stock purchases?
Only in certain instances. The majority of investors average down with the expectation that the stock would rebound. While this is possible, the deeper a stock falls, the more difficult it is to return to breakeven or profit. However, stock indexes do tend to climb over time, so investors in long-term index ETFs may benefit by averaging down if they have a sufficiently long time horizon.
How is a breakeven point calculated while averaging down?
There is no way to determine a precise breakeven point while averaging down. The strategy will only be successful if the stock ultimately recovers and the price increases. If it continues to decline, you will lose money; the only decision is when to cut your losses.
Is averaging down a strategy to conceal an error in-stock purchase?
It might be a mistake to invest to average down in order to make a purchase seem more favorable. Traders have been known to use the average-down strategy to make the original stock purchase seem favorable. If the company’s price continues to decline, it becomes more difficult to conceal the fact that you acquired falling stock.