When a stock you own declines in value, you may be wondering what to do next. You can sell and accept the loss, do nothing and hope the stock’s value climbs again or buy additional shares while the price is low. This third strategy, known as averaging down, could allow you to increase your position in a particular stock at a discount. An average down approach could pay off if those shares eventually increase in value but it’s important to understand how it works and the risks involved. A host of considerations go into buy-and-sell decisions; let a financial advisor help you think through relevant factors.
Averaging Down Definition
Averaging down is an investment strategy that involves buying additional shares of stock when a security’s price drops. It’s called averaging down because when you buy more shares of a stock you already own at a lower price, that lowers the average cost per share of what you own.
This is essentially how a dollar-cost averaging strategy works. When you use dollar-cost averaging to invest, you continue putting money into the market regularly, regardless of what’s happening with stock prices. The idea is that by investing continuously through different market cycles, your returns will more or less even out.
Averaging down is the opposite of averaging up. When you average up, you’re buying more shares of stock as their value rises. This raises the average cost per share of what you own.
Averaging Down Example
It’s helpful to have an example or two to understand how averaging down works and why you might use this strategy to invest.
Say you buy 100 shares of stock at $50 each, for a total investment of $5,000.
Stock market volatility causes the stock’s per-share price to drop to $25, half what you originally paid for it. You decide to buy an additional 100 shares, putting your total investment at $7,500. Since the share price has dropped, your shares are now worth $37.50 on average ($7,500 / 200 shares).
What happens next with the stock’s price can determine whether you gain or lose money on your investment. So, say that the stock’s price climbs to $75. If you own 200 shares, they’d be worth $15,000, which is double the $7,500 you invested to purchase them.
In that scenario, averaging down has worked in your favor because you’ve essentially doubled your money just by being patient and waiting for the stock’s price to rebound. But what if the market turns bearish and the price continues to fall and drops to $15?
Now your investment is only worth $3,000, less than half what you paid to buy those shares. This type of averaging down example is simplistic but it illustrates how this strategy may or may not work in your favor, depending on market conditions.
Advantages of Averaging Down Stocks
The primary benefit of averaging down stocks is that you have the potential to reap sizable gains if you’re able to buy low and sell high later on. But this requires some knowledge of how market cycles work and the ability to distinguish a stock that’s experiencing a short-term downturn versus one that’s stuck in a steady pattern of declining share prices. This is similar to buying the dip. This is similar to the way value investing works and being able to spot value traps. With a value investing approach, you’re looking for stocks that have been undervalued by the market and otherwise have the potential for significant capital appreciation over time. A value trap, however, is a company that looks undervalued but really isn’t.
Learning the basics of fundamental analysis as well as how to use technical indicators to gauge what’s happening with a particular stock can help with identifying investments that might be good targets for averaging down. For example, a company that’s restructuring might see share prices drop temporarily but recover if its financials (i.e. revenue, profit, debt levels, etc.) are otherwise strong.
An averaging down play could put you ahead if the company’s stock price starts to climb after the reorganization is complete. Doing some simple calculations to estimate potential gains can help with deciding whether it makes sense to try and average down a stock.
Disadvantages of Averaging Down
The chief risk of averaging down is that a stock’s price doesn’t climb higher or worse, continues to drop. In that scenario, you can lose money on the investment. Again, understanding the underlying fundamentals of a particular company and what’s happening in the markets can help with gauging this risk, though it doesn’t eliminate it entirely.
And it can be difficult to use an average down approach when volatility is high because of economic uncertainty. When something like a correction happens, that can create buying opportunities for investors who are more risk-tolerant. But if a correction doesn’t resolve quickly and leads to a recession, then you have to be fairly certain that the companies you own are able to bounce back.
It’s also important to consider how buying additional shares of a particular stock might affect your portfolio’s overall asset allocation. It’s possible that taking advantage of lower prices could result in your portfolio being overweighted in one particular sector. For example, you might end up with a big chunk of your asset allocation dedicated to tech or energy stocks.
That can increase your risk exposure so it’s important to be mindful of how you’re spreading out your investment dollars. This is where rebalancing comes into play to help you stay aligned with your target risk profile.
How to Use Averaging Down to Invest
If you’re comfortable with the risks of an average down strategy, these tips can help with executing it in your portfolio.
- Do your research. Again, it’s important to check a company’s fundamentals to get a sense of how financially sound it is before attempting to average down. This can help with distinguishing short-term price drops from a long-term downward trend.
- Check market conditions. Aside from examining what may be causing a company’s price to drop internally, also consider the larger market as a whole. Look at the market cycle and what may be spurring volatility to gauge how likely current pricing trends are to continue.
- Set limits. One way to minimize loss potential with averaging down is to choose an exit point at which you’ll sell your position or a point at which you’ll no longer purchase additional shares. Having these kinds of limits in place can help you avoid pouring more money into what may be a losing stock. This is sometimes
The Bottom Line
Averaging down is a variation on dollar-cost averaging, which is a strategy you might use if you’re a long-term buy-and-hold investor. It results in lowering the average price at which you purchased a particular security; it’s the opposite of averaging up, which has the opposite effect. Understanding the potential upsides as well as the downsides can help you determine whether it makes sense to average down stocks in your portfolio.
Tips for Investing
- Consider talking to a financial advisor about dollar-cost average and how to average down stocks in your portfolio. If you don’t have a financial advisor, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors online. You can get personalized recommendations for advisors in your local area in minutes. If you’re ready, get started now.
- One of the most useful tools investors have is an asset allocation calculator, which helps portfolios maintain the desired balance among asset classes.
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