There are two main schools of thought when it comes to averaging up and down: some people believe that averaging up is the best strategy, while others think that averaging down is the way to go. So, what are the advantages and disadvantages of averaging up vs averaging down? Which one is the right choice for you?
In this article, we will explore the pros and cons of each approach, so that you can make an informed decision about which one is best for your portfolio.
What is averaging up?
Averaging up is when you buy more of a security after it has risen in price. The logic behind this strategy is that you are buying the security at a lower price than it will eventually be worth. This means that you believe that the price will increase over time.
By averaging up, you do not have to worry about missed opportunities. However, this is only true if you are correct with your assessment of the security.
Advantages of averaging up
There are several advantages to averaging up. First of all, it allows you to keep gaining more shares before the price starts to rise even more. This is a good way to increase your position as a quality asset.
Secondly, averaging up allows you to take advantage of compounding returns. This is because as the price of the security goes up, your profits will increase as well. Compounding is when you reinvest your profits and use them to buy more shares. This amplifies your returns over time.
Finally, averaging up can be a simple way of investing. This is because you are not constantly buying and selling securities. This can save you time and money in transaction costs.
Disadvantages of averaging up
There are also some disadvantages to averaging up. First of all, it is a risky strategy. This is because you are putting all your eggs in one basket and relying on the security to go up. If the security does not go up, then you will lose money.
Secondly, averaging up can be emotionally difficult. This is because it can be hard to see if the price of a security goes down. This can cause you to sell at a loss and miss out on potential profits.
Finally, averaging up can lead to buying companies that are overvalued. Just because a company has had a track record of going up, does not mean that it will continue to do so. This can lead to you paying too much for security.
What is averaging down?
Averaging down is when you buy more of a security after it has fallen in price. The thought process behind this strategy is that you are buying the security at a lower price than it will eventually be worth, so you are averaging down the price over time.
This lowers your average cost per share. Let’s look at some of the advantages and disadvantages of averaging down.
Advantages of averaging down
There are many advantages to averaging down. First, when you average down, you lower your overall cost basis. This is important because it means that your profits will be higher when you finally do sell.
For example, let's say you buy a stock for $50 and it falls to $40. If you buy more at $40, your cost basis is lowered. If the stock rises in value, it can be easier for it to become a profitable investment. This is because you need the stock to only rise to the new average cost rather than its original purchase price.
Another advantage is that averaging down forces you to buy more of a stock when it is "on sale." This is a great way to build up a position in a company that you believe in over the long term.
Finally, averaging down can help to ease your emotions. When a stock is falling, it's easy to get scared and want to sell. If you have a plan to average down, then you can stick to that plan and not let your emotions get the best of you.
Disadvantages of averaging down
There are also many disadvantages to averaging down. The first is that it can be a very risky strategy. If the stock continues to fall, you could end up losing a lot of money. This can often be referred to as 'Catching a Falling Knife.'
Another disadvantage is that it can tie up a lot of your capital in one stock. This can be dangerous if the company runs into financial trouble or if the stock price falls below your cost basis and becomes difficult to sell.
Finally, averaging down can also lead to "analysis paralysis." This is when you become so focused on trying to find the bottom that you miss out on other opportunities. This is it is important to know how and when to average down.
Is averaging up better than averaging down?
There is no right or wrong answer when it comes to averaging up vs averaging down. It all depends on your risk tolerance and your overall investment strategy. If you're the type of investor who is comfortable with a little more risk, then averaging down might be a good strategy for you.
However, if you're looking for a safer way to grow your portfolio, then averaging up could be the better choice. At the end of the day, the most important thing is that you have a plan and you stick to it. If you're constantly changing your strategy, then it will be very difficult to achieve your long-term investment goals.
Should you buy more when it goes up or down?
This depends on the underlying stock. For example, if a company is doing amazing and the financials, products, etc. are all great then you might want to buy more when the stock is going up (averaging up).
On the other hand, if a company is in trouble and the stock price has already fallen significantly, then averaging down might be a better strategy. This is because the stock may never recover and you will continue to lose money. It's important to remember that it depends on the individual investor and the individual asset.
Each situation should be addressed separately. The best way to prepare yourself for this decision is to read more articles on this website. By doing so, you will develop a better understanding of how to make this decision.