Deciding whether or not to purchase additional shares of a stock that is falling in price is an interesting question, and the answer has two parts. On the one hand, you can add more to a good position when prices are relatively cheaper. On the other, you may be compounding a losing position. So, should you buy the dip?
First, let's address the concept underlying the average down strategy, and then discuss the validity of this strategy.
- Averaging down is a strategy to buy more of an asset as its price falls, resulting in a lower overall average purchase price.
- It is sometimes known as buying the dip.
- Adding to a position when the price drops, or buying the dips, can be profitable during secular bull markets.
- However, it can also compound losses during downtrends.
- Adding more shares increases risk exposure and inexperienced investors may not be able to tell the difference between a value and a warning sign when share prices drop.
What Is Averaging Down?
Buying more shares at a lower price than what you previously paid is known as averaging down, or lowering the average price at which you purchased a company's shares.
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."
However, even though your average purchase price would've gone down, you would've had an equal loss on your original stock—a $10 decrease on 100 shares renders a total loss of $1,000. Purchasing more shares to average down the price wouldn't change that fact, so do not misinterpret averaging down as a means to magically decrease your loss.
When to Apply Averaging Down
There are no hard-and-fast rules. You must re-evaluate the company you own and determine the reasons for the fall in price. If you feel the stock has fallen because the market has overreacted to something, then buying more shares may be a good thing. Likewise, if you feel there has been no fundamental change to the company, then a lower share price may be a great opportunity to scoop up some more stock at a bargain.
The problem is that the average investor has very little ability to distinguish between a temporary drop in price and a warning signal that prices are about to go much lower. While there may be unrecognized intrinsic value, buying additional shares simply to lower an average cost of ownership may not be a good reason to increase the percentage of the investor's portfolio exposed to the price action of that one stock. Proponents of the technique view averaging down as a cost-effective approach to wealth accumulation; opponents view it as a recipe for disaster.
The strategy is often favored by investors who have a long-term investment horizon and a value-driven approach to investing. Investors that follow carefully constructed models they trust might find that adding exposure to a stock that is undervalued, using careful risk-management techniques, can represent a worthwhile opportunity over time. Many professional investors who follow value-oriented strategies, including Warren Buffett, have successfully used averaging down as part of a larger strategy carefully executed over time.
Averaging down is similar to dollar-cost averaging (DCA), an investment strategy where one divides up the total amount to be invested across periodic purchases. With averaging down, however, new purchases are only made on dips.
When Is Averaging Down a Good Idea?
Averaging down works best when you are confident that an investment is a long-run winner. As such, buying the dips will have you accumulating your position at progressively better prices, making your ultimate profit potential greater.
Can You Lose Money Averaging Down?
Yes. If you keep buying more shares a stock sinks without bouncing back, you will end up holding a larger position at a loss.
What Is Averaging Up?
Opposite from averaging down, averaging up involves buying more shares as a stock rises. This increases the average price paid for a position, but if you are buying into an up-trend, it can amplify your returns. Like averaging down, an average-up strategy could result in larger losses if the stock falls sharply from a peak.
The Bottom Line
It's important to realize that it is not advisable to simply buy shares of any company whose shares have just declined. Even though you are averaging down, you may still be buying into an ailing company that will continue its downslide. Sometimes the best thing to do when your company's stock has fallen is to dump the shares you already have and cut your losses.