First, determine the reason for the fall in stock price
Reviewed by Charles PottersFact checked by Amanda JacksonReviewed by Charles PottersFact checked by Amanda Jackson
Individuals commonly try to follow the adage, “buy low and sell high.” When following the average down strategy, investors consider two factors when deciding whether or not to purchase additional shares of a stock that is falling in price. They add more to a good position when prices are relatively cheaper. However, they may be compounding a losing position. Should they buy the dip?
Key Takweaways
- Averaging down is a strategy to buy more of an asset as its price falls, resulting in a lower overall average purchase price.
- Averaging down is sometimes known as buying the dip.
- Adding more shares increases risk exposure and inexperienced investors may be unable to differentiate between a value and a warning sign when share prices drop.
What Is Averaging Down?
Buying more shares at a lower price than an investor previously paid is known as averaging down, or lowering the average price at which they purchased a company’s shares.
For example, say an individual bought 100 shares of XYZ Company at $20 per share. If the stock fell to $10, and they bought another 100 shares, the average price per share would be $15, essentially decreasing the price originally paid by $5. This is sometimes called “buying the dip.”
However, even though the average purchase price would’ve gone down, there is an equal loss on the original stock—a $10 decrease on 100 shares renders a total loss of $1,000. Purchasing more shares to average down does not decrease an investor’s loss.
Note
Averaging down is considered to be a value-oriented investing strategy.
Investment Timing
Investors should always evaluate the company they own and determine the reasons for any fall in stock price. If the market is overreacted to something, buying more shares may prove wise. Likewise, if there has been no fundamental change to the company, a lower share price may be a great opportunity to scoop up more stock at a bargain.
However, the average investor may be unable to distinguish between a temporary drop in price and a warning signal that prices are about to go much lower. Buying additional shares 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.
Investors who follow carefully constructed models they trust might find that adding exposure to an undervalued stock, using careful risk-management techniques, may represent a worthwhile opportunity over time.
Note
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?
An averaging down strategy works best only when investors are confident that an investment is a long-run winner. As such, buying the dips helps accumulate a position at progressively better prices, making profit potential greater.
Can Investors Lose Money Averaging Down?
Yes. If investors keep buying more shares of a stock where the price does not bounce back, they will hold 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. Investors who buy into an up-trend can amplify returns. Like averaging down, an average-up strategy could result in larger losses if the stock falls sharply from a peak.
The Bottom Line
Buying more shares at a lower price than an investor previously paid is known as averaging down, or lowering the average price. Investors should evaluate the reasons behind a stock’s price decline before buying the dip or averaging down.
Read the original article on Investopedia.