Averaging down is the term used to describe the strategy of buying a further amount of shares at a lower price than was originally paid, and as a result, lowering the average paid for each share. For example, if 100 shares were purchased at $20 per share, and then a further 100 shares were purchased at $18 per share; the average cost per share is lowered to $19. What this means is that if the share price rises to $19, then the investor breaks even. If the price returns to $20, then a profit is made.
Is this a Good Investment Strategy?
There is some difference of opinion over whether this method is a viable strategy with a good possibility of leading to a greater percentage profit in the long run, or whether it is more likely to result in a greater loss as a consequence of holding a larger amount of shares with reduced value. This must be assessed on the basis of an individual investment. There are some questions that can help to determine whether averaging down is a wise move or not. Firstly, it must be considered whether the stock is likely to regain its value, and this determination can be best made by studying the fundamental value of the stock, and external factors that are likely to influence its performance in the short- or longer-term.
What Type of Investors Can Benefit from Averaging Down?
Another important question to consider when contemplating this strategy is whether you, the investor, are willing and able to hold the investment long enough for it to turn around. Many traders do not consider it a viable proposition to invest even more money in a position that may take a considerable amount of time to recoup the investment, making the decision to buy a further amount of shares a more popular strategy among longer-term investors, who are willing to buy and hold.
An investor deciding to apply this strategy does so with the goal of lowering the point at which their investment will break-even, and increasing their potential gain. The risk is, of course, that should the stock continue to decline, then the losses will be greater than they would have been had the investor not decided to buy more shares at a lower price.
Another point to keep in mind when considering averaging down is whether purchasing additional stocks in a particular company or sector will lead to an unbalancing of the investor’s portfolio.
Consider Each Stock Individually
When deciding to buy more shares at a lower price, the investor should make sure that the stock in consideration meets some basic criteria. A stock in a blue-chip company, where the fundamental value is strong, makes a relatively good candidate for the practice of averaging down. These stocks have a good chance of recouping their value, and are less likely to be vulnerable to corporate bankruptcy.
While applying this strategy can certainly be a method of increasing profits by benefiting from a short-term downturn in prices, it is suitable only for investors with certain goals and styles of investing, and for stocks that can be deemed likely to recoup temporary losses in value.
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