Averaging down is one of the most common investment strategies that you can use to lower your cost basis on a stock. But when should you average down? And what are the advantages and disadvantages of doing it?
In this guide, we will cover some of the main advantages and disadvantages of averaging down.
What is averaging down?
Averaging down in stocks is when an investor buys more shares of the same stock to add to an existing position as the price of the stock declines. Since the investor is able to add more shares at a lower price per share, this lowers its cost basis.
It is used as a way to reduce losses, and improve the potential returns. Additionally, if you invest in a stock at $10 a share, and it looks like a great deal, why not buy more shares when it reaches $8.
However, to average down takes a lot of determination because most investors do not want to add to their existing positions if they decline in price. In fact, they might feel pressured to sell the stock, and look for another stock that is more attractive. This is why it is important to know how to average down correctly, and when to do it.
How averaging down works
When you buy a stock and the price goes down, there are 3 things you can do:
- Average down
Averaging down involves buying more shares as the price continues to decline. Let’s look at a practical example:
Averaging down example
Imagine you bought stock 100 shares of stock XYZ for $10, that means you have spent $1,000 plus fees.
If the stock goes down to $8 dollars your initial investment is now only worth $800. If you add 100 more shares at $8 dollars you will have spent $1,800 and you control 200 shares, with an average price of $9. Your 200 shares will be worth $1,600 with the stock price being $8.
This means that you will own 200 shares at an average price of $9. Your loss on the first 100 shares you bought remains the same.
However, to break even the stock only needs to go up by 12.5%, instead of the 25%, it would be necessary if you did not average down. This is one of the best advantages if you decided to average down since it allows you to lower your cost basis and lower your breakeven price level.
So what are the advantages and disadvantages of averaging down?
What are the advantages of averaging down?
Here are some of the main advantages:
- Lower cost basis price
- Easier to control your emotions when investing
- Lower your breakeven price level
- Allows you to add your favorite stocks at lower prices
- It is one of the best approaches for long-term investors
- Increases your potential returns on the stock
Lower cost basis price
Averaging down a stock allows you to lower the price per share paid, which can help you break even with a lower increase in the stock price, or even achieve higher returns.
Easier to control your emotions when investing
Averaging down also helps you to keep your emotions in check. Instead of investing a lump sum of money, you can start with an initial order on each stock, and add if the price goes down. This way you will be able to control all of the negative emotions associated with paper losses.
Lower your breakeven price level
As we have mentioned, lowering your cost basis means that the stock does not need to increase as much in price for you to break even.
Allows you to add your favorite stocks at lower prices
If you are a long-term investor with a long investment horizon, averaging down is a great way to constantly add to your favorite stocks. You may also take a dollar-cost averaging approach if you want to invest a fixed amount of dollars vs buying shares.
It is one of the best approaches for long-term investors
For long-term investors averaging down is a great way to add more of the stocks you want to hold for years. This allows you to take advantage of short-term volatility, and reduced prices on high-quality stocks.
Increases your potential returns on the stock
Finally, averaging down also allows you to boost your returns. Since you reduce your cost basis, it allows you to make a higher return, than just keeping the initial shares you bought.
What are the disadvantages of averaging down?
Some of the main disadvantages of averaging down include:
- You could be averaging down on a value trap
- Increases your exposure to the stock
- Increase the risk and volatility of your portfolio
- You might be too exposed to that stock
- It does not work if your investment horizon is short
- Averaging down needs to be based on fundamental analysis
You could be averaging down on a value trap
If you accidentally choose the wrong stock you could be averaging down on a value trap. This is one of the main disadvantages of this investment approach because you could be adding to losing stocks, while you could be investing in other attractive stocks. However, there are ways to identify value traps, so you can avoid averaging down on the wrong stocks.
Increases your exposure to the stock
If you average down you increase the exposure to the stock, and this carries additional risk and volatility to your investment portfolio. You want to avoid adding to stocks that are too volatile, or risky. This could put your investment portfolio at risk.
Increases the risk and volatility of your portfolio
When you have a larger position in your portfolio, it increases the volatility. It also increases the risk of your portfolio since you are not as diversified.
Although there are some benefits of having a concentrated portfolio, you need to make sure you are averaging down on a business with competitive advantages that will perform well in the future.
You might be too exposed to that stock
Failing to diversify your portfolio could really impact your returns, if you happen to choose the wrong stocks, and make any mistakes. Even the most experienced stock pickers are wrong sometimes. It is always wise to diversify your investments to reduce the volatility and risk.
It does not work if your investment horizon is short
If you have a short investment horizon, or you are just trading stocks, averaging down may not be the best investment approach. The reason is that there is no guarantee that the stock price will increase in the short term. Therefore, averaging down is the best approach if you are investing for the long run.
Averaging down needs to be based on fundamental analysis
Lastly, you always need to do your own research based on fundamental analysis, to determine why the stock is attractive, and if the valuation makes sense. Averaging down on a stock solely based on how the stock price has been fluctuating could put your investment at risk.
Is averaging down a good idea?
If you are investing for the long term in quality companies averaging down is always the right step to take. As long as the valuation is justified, averaging down allows you to lower your cost basis significantly, and benefit from higher returns. Additionally, when you add to a losing stock, your breakeven price level will be lower, and if the stock bounces back, it will be easier to break even and even generate some profits.
Do you lose money when averaging down?
No, you do not lose money when you average down unless the stock suddenly collapses after you purchased it. Overall, averaging down ensures that your cost basis is lower, and therefore you are more likely to make money on the stock.
Is it better to average up or down?
If the stock you want to add has a competitive advantage and is fairly priced it always makes sense to average both up or down. However, averaging down tends to produce the best returns, if the stock price reverses, or a stock rerating pushes the stock price to previous levels.
Averaging down remains one of the most common investing approaches due to how simple and effective it is. If you are a long-term investor, it is always a good option to consider averaging down.
Stock prices fluctuate often and you want to make sure you take advantage of lower prices and add your favorite long-term stocks when they are on sale.
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