What Is Average Down?
Averaging down is an investing strategy in which a stock owner purchases additional shares of a previously initiated investment after the price has dropped further. The result of this second purchase is a decrease in the average price at which the investor purchased the stock. As an example, an investor who bought 100 shares of a stock at $50 per share might purchase an additional 100 shares if the price of the stock reached $40 per share, thus bringing her average price (or cost basis) down to $45 per share. Some financial advisors encourage stock investors to adopt this strategy with stocks or funds they intend to buy and hold.
- Averaging down means adding to an investment when its price drops.
- This technique can be useful when carefully applied with other components of a sound investing strategy.
- 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.
Understanding Average Down Strategy
The main idea behind the strategy of averaging down, is that when prices rise, they don't have to rise as far for the investor to be showing a profit on their position. Consider that if an investor purchased 100 shares of stock at $60 per share, and the stock dropped to $40 per share in price, the investor has to wait for the stock to make its way back up from a 33% drop in price. However, measuring from the new price of $40, it's not a 33% rise, the stock must now increase by 50% before the position will show a profit (from 40 to 60).
Averaging down helps address this mathematical reality. If the investor purchase an additional 100 shares of stock at $40 per share, now the price must only rise to $50 (only 25% higher) before the position is profitable. Should the stock return to its original price and move higher thereafter, the investor will begin by noticing a 16% profit once the stock hits $60.
Although averaging down offers some aspects of a strategy, it is incomplete. Averaging down is really an action that comes more from a state of mind than from a sound investment strategy. Averaging down allows an investor to cope with various cognitive or emotional biases. It acts more as a security blanket than a rational policy.
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.