In the stock market, every price movement is an opportunity, be it during a bull or bear run. Short-term fluctuations in share prices can be an opportunity for an investor to average down his investment costs to minimise losses or make higher profits than when he set out originally.
Table of Contents
- What Does Average Down Mean?
- Example of Averaging Down
- When to Average Down as an Investment Strategy?
- Pros and Cons of Averaging Down
- Frequently Asked Questions
What Does Average Down Mean?
Averaging down is an investment strategy where you buy more assets such as equity shares when their prices drop. This brings your average cost per share down. The strategy resembles dollar-cost averaging. Buying more shares after the price drops will reduce your breakeven price. However, your risk exposure also increases, as you now own more shares.
If the stock price moves up after you have purchased the additional shares, your profit will increase as your average price has been lowered. But if the share price goes down further, your original loss will widen.
Example of Averaging Down
Suppose an investor holds 10 shares of Company XYZ, whose share price has gone down from US$50/share to US$45/share. His loss is US$5/share if he sells his shares.
However, he believes that the market is unduly pessimistic about the company and that the share price will recover eventually. He snaps up 10 more shares at US$45/share.
His paper loss = 50 – {(10*50 + 10*45) / 20} = 50 – 47.5 = US$2.50/share.
This is lower than his original potential loss of US$5/share.
When to Average Down as an Investment Strategy?
If you are a long-term investor and your original reason for liking and buying a stock still applies, it makes sense to accumulate its shares.
However, if something fundamental has changed about that company, such as a loss of market share to competitors or slowing sales growth, averaging down may not be a good idea as you could be throwing good money after bad.
Pros and Cons of Averaging Down
The most notable advantage of averaging down is lowering your average cost of investment. Buying more shares as the price drops reduces your average cost per share. If sentiment improves later and the share price goes up, you stand to earn more profits from your ownership of more shares.
The main disadvantage of averaging down is increased risk. By averaging down, you’re also increasing the size of your investment. So if the share price continues to fall, your losses will become greater than your original position.
Frequently Asked Questions
How do I calculate my average cost price after averaging down?
Average cost price = (Sum of prices of all my shares) / (Total number of shares)
Lump-sum investing versus average down: which is better?
In lump-sum investing, you invest a big sum of money into an asset. You gain exposure to that asset immediately. When markets are on an uptrend, putting your money to work right away helps you take full advantage of price growth.
In averaging down, you buy more stocks when prices are falling. Averaging down may be appropriate when you want to minimise the downside risk from a huge investment or take advantage of the market’s naturalvolatility to lower your average price.
https://investor.vanguard.com/investing/online-trading/invest-lump-sum
Does averaging down mean I can’t “buy low and sell high”?
No, the whole idea behind averaging down is to buy low and sell high i.e. buy more shares in a bearish market at a low price and sell them in a bullish market at a higher price.
FAQs
Pros and Cons of Averaging Down
What is a risk of averaging down? ›
Averaging down is a risky strategy of buying more stock after a significant price drop. That lowers the cost per share, but the average cost is still higher than the market value. Although the difference to breakeven is smaller, that stock's portion of the portfolio and the total investment increase.
What is an example of averaging down? ›
For example, say you bought 100 shares of the TSJ Sports Conglomerate at $20 per share. If the stock fell to $10, and you bought another 100 shares, your average price per share would be $15. You would be decreasing the price at which you originally owned the stock by $5. This is sometimes called "buying the dip."
What are the benefits of averaging down stocks? ›
Pros of averaging down
This reduces your average cost basis, making it easier to break even or earn a profit. Increased potential gains: Value investors have long known that buying the dip can yield increased potential for gains, given enough time.
Should you keep averaging down? ›
Averaging down can be an effective strategy if you believe that the stock's current price does not reflect its true value. However, this strategy should not be used blindly, as it can lead to significant losses if the stock's fundamentals do not improve.
Is averaging down effective? ›
Averaging down is only effective if the stock eventually rebounds because it has the effect of magnifying gains.
Why may averaging down result in poor investment decisions? ›
As with any strategy, there's risk in averaging down. If, after averaging down, the price of the stock goes up, then your decision to buy more of that stock at a lower price would have been a good one. But the stock continues its downward price trajectory, it would mean you just doubled down on a losing investment.
What happens when you average down on a stock? ›
Average down refers to an investor's approach while investing in stocks or shares to maintain a sustainable portfolio. Under this approach, an investor buys additional shares or doubles the number of shares purchased previously in their stock to decrease the average purchase price of the investor.
What is averaging down into losing positions? ›
Averaging down is adding to a position as the trade loses money. The logic is that buying at lower prices reduces the average price of the position. This increases the gain if the price goes back up, or gets the trader back to break even quicker.
Is averaging good or bad in stock market? ›
Bad stocks are always the first to decline. On the other hand, averaging up in stock markets helps you enter winning counters. If a stock is seeing sustained buying, it means, a large number of investors must be bullish on its prospects. By averaging up, you get an opportunity to gain from the upward movement.
Key Takeaways. When a stock tumbles and an investor loses money, the money doesn't get redistributed to someone else. Drops in account value reflect dwindling investor interest and a change in investor perception of the stock.
How does averaging help? ›
In a bull market, averaging lowers the cost of newly bought units. Nonetheless, in a bear market, averaging lowers losses as the average purchase price decreases. The principle that revolves around the averaging concept is purchasing a specific asset multiple times but at different prices.
Do you owe money if a stock goes negative? ›
No. A stock price can't go negative, or, that is, fall below zero. So an investor does not owe anyone money. They will, however, lose whatever money they invested in the stock if the stock falls to zero.
Does dollar-cost averaging decrease risk? ›
Dollar-cost averaging can be a helpful tool in lowering risk. But investors who engage in this investing strategy may forfeit potentially higher returns.
