The strategy of "averaging down" refers to buying more shares of a falling stock that you already own. When you do that, you are driving down the average price of the stock that you have, which lowers the break-even price – the price at which you could sell all your shares of that stock and break even.
Is this a good idea? Some very successful business investors, such as Warren Buffett, use elements of this strategy. For others, it is like doubling down at the blackjack table – only successful if you know what you are doing, and are a little lucky to boot. Both have a point. Consider these factors:
- Knowledge of the Stock –The old philosophy of "buy low, sell high" works when you actually are buying at the low point. (The challenge, of course, is knowing when that point has arrived.) Similarly, averaging down is only a good idea if the stock rebounds. It is critically important that you understand why the stock is falling, and that you can reasonably predict whether it will rise again. Otherwise, you can join your friend at the blackjack table.
If you plan to average down on any stock, look at its fundamentals and valuation ratios very carefully. Is this overvalued stock re-equilibrating to a more reasonable P/E ratio? What is their cash situation? Do they have excessive debt? Are they delaying new product launches? Are they losing market share?
If you have good reason to believe the stock will turn around, then averaging down may well be a good choice.
- Investing Time Horizon – Are you investing short-term in the stock, or long-term in the company? The shorter your holding time is, the less sense it makes for you to average down.
If you are buying at what appears to be a bargain rate for a long-term turnaround, averaging down makes sense – assuming you are correct that the stock will eventually rise. Conversely, if you are a trader only trying to make a quick profit, you may want to cut your losses.
- Overall Market – An overall poor economy can derail the turnaround of an otherwise promising company; likewise, a good economy can temporarily hide the sins of a poorly run company. Again, it is best to focus on the fundamentals to determine if your stock is falling as part of an overall market correction, or for company-specific reasons that may throttle your strategy.
Why average down? Proponents say that if you are correct, you make money. For example, let's say you buy 100 shares at $100, the price drops to $90, and you buy 100 more shares. Your per share average drops from $100 to $95. If the stock rises to $98, you made $600 ($3 x 200 shares), even though you paid more than $98 for some of your shares.
In reality, this is just correctly picking stocks – it does not matter whether or not you already own some. Let's assume that instead of averaging down in the last example, you bought 100 shares of a completely different stock at $90. Both stocks close at $98. Your loss on the first stock has been reduced to $200 (-$2 x 100 shares), and your gain on the other is $800 ($8 x 100 shares). Combined, it is still a $600 gain.
Another potential disadvantage is that you may be unbalancing your portfolio by concentrating on a particular stock. If you do average down, consider your portfolio diversification.
For many investors, averaging down may not be not the best choice. You should be focusing on stocks that are likely to rise in value, whether or not you already happen to own them.
For those who do average down, it is best to look for temporary dips in blue chip stocks, with solid fundamentals, that you can hold for the long term. Otherwise, you had better have incredible instincts and insight on predicting stock turnarounds.