What Is Average Down?
Averaging down is an investing strategy that involves a stock owner purchasing additional shares of a previously initiated investment after the price has dropped. The result of this second purchase is a decrease in the average price at which the investor purchased the stock. It may be contrasted with averaging up.
For 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 their average price (or cost basis) down to $45 per share. Some financial advisors encourage investors to adopt averaging down with stocks or funds they intend to buy and hold or as part of a dollar-cost averaging (DCA) strategy.
Key Takeaways
- Averaging down is an investment strategy that involves adding to an existing position when its price drops.
- This technique can be useful when carefully applied with other components of a sound investing strategy.
- Adding more to a position, however, increases overall 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 the 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 begin 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 purchases 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.
Special Considerations
The problem with averaging down 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.
This 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.
FAQs
Averaging down is an investing strategy that involves a stock owner purchasing additional shares of a previously initiated investment after the price has dropped. The result of this second purchase is a decrease in the average price at which the investor purchased the stock. It may be contrasted with averaging up.
What are averaging down strategies? ›
As an investment strategy, averaging down involves investing additional amounts in a financial instrument or asset if it declines significantly in price after the original investment is made. While this can bring down the average cost of the instrument or asset, it may not lead to great returns.
What are the pros and cons of averaging down? ›
Pros and Cons of Averaging Down
Buying more shares as the price drops reduces your average cost per share. If sentiment improves later and the share price goes up, you stand to earn more profits from your ownership of more shares. The main disadvantage of averaging down is increased risk.
How to calculate average down? ›
Use the average down stock formula below to calculate the new breakeven price: [(# of shares x purchase price) + (# of shares x second purchase price)] / total # of shares.
Is it better to average down or sell and rebuy? ›
Sell the loser and buy the winner. Averaging down significantly increases risk. If we are wrong on a decision to average down, we kill our investment performance.
What is an example of average down? ›
For 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 their average price (or cost basis) down to $45 per share.
How many shares to buy to average down? ›
To calculate how much stock to buy to get the average price down to a certain level, you can use the following formula: Determine the current average price of your stock:Average Price = Total Cost of Existing Shares / Total Number of Existing Shares. Set the target average price you want to achieve.
Is averaging down smart? ›
Potential Risk of Averaging Down
If, after averaging down, the price of the stock goes up, then your decision to buy more of that stock at a lower price would have been a good one. But the stock continues its downward price trajectory, it would mean you just doubled down on a losing investment.
Does averaging down reduce losses? ›
By doubling down and increasing your exposure, you also raise your potential profit if the price rebounds. Risk management: No one likes losing money. Averaging down helps you preserve value by reducing your losses per share.
How to average down on options? ›
To “average down” is to buy more of the same stock (or option or futures contract) at a lower price. In other words, your first purchase is now losing money, and you are going to add more to the position to lower your overall average cost.
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.
Do you owe money if a stock goes negative? ›
A stock price can't go negative, or, that is, fall below zero. So an investor does not owe anyone money. They will, however, lose whatever money they invested in the stock if the stock falls to zero.
Do you buy stocks when they are low or high? ›
The best time to buy a stock is when an investor has done their research and due diligence, and decided that the investment fits their overall strategy. With that in mind, buying a stock when it is down may be a good idea – and better than buying a stock when it is high.
Is it smart to sell stock at a loss and rebuy? ›
If you sell a stock at a loss and quickly buy it back or keep investing in it after buying it back, the IRS generally won't allow you to write off the loss on your federal tax return.
What is a downside of the share price dropping? ›
Key Takeaways. When a stock tumbles and an investor loses money, the money doesn't get redistributed to someone else. Drops in account value reflect dwindling investor interest and a change in investor perception of the stock.
What happens to a company when stock prices fall to zero? ›
If a stock falls to or close to zero, it means that the company is effectively bankrupt and has no value to shareholders. “A company typically goes to zero when it becomes bankrupt or is technically insolvent, such as Silicon Valley Bank,” says Darren Sissons, partner and portfolio manager at Campbell, Lee & Ross.
What is averaging strategy? ›
Averaging Up
This strategy involves buying more shares when the price rises above the initial purchase price. This increases the average cost of the shares held but also increases the profit potential. This strategy can be useful when the trader is confident that the price will continue to rise in the future.
What are averaging techniques? ›
Various averaging techniques, including time, spatial, and area averaging, are used to obtain nondimensional parameters that correlate the experimental data as well as flow maps for two-phase flow.
What is averaging down vs averaging up? ›
Investors and traders like to average up because they view the price increase as validation of their original thesis. Averaging down is the opposite of averaging up; traders buy more to “average down” even though the price has gone down.
