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. First, let's address the concept underlying the 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.
- Adding to a position when the price drops, or buying the dips, can be profitable during secular bull markets, but can 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?
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 this 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.
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.