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. On the one hand, you can add more to a good position when prices are relatively cheaper. On the other, you may be compounding a losing position. So, should you buy the dip?
First, let's address the concept underlying the average down strategy, and then discuss the validity of this strategy.
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.
- It is sometimes known as buying the dip.
- Adding to a position when the price drops, or buying the dips, can be profitable during secular bull markets.
- However, it can also 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?
Buying more shares at a lower price than what you previously paid is known as averaging down, or lowering the average price at which you purchased a company's shares.
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 avalue-drivenapproach to investing. Investors that follow carefully constructed models they trust might find that adding exposure to a stock that is undervalued, using carefulrisk-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.
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?
Averaging down works best when you are confident that an investment is a long-run winner. As such, buying the dips will have you accumulating your position at progressively better prices, making your ultimate profit potential greater.
Can You Lose Money Averaging Down?
Yes. If you keep buying more shares a stock sinks without bouncing back, you will end up holding 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, but if you are buying into an up-trend, it can amplify your returns. Like averaging down, an average-up strategy could result in larger losses if the stock falls sharply from a peak.
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.
FAQs
Averaging down is a strategy to buy more of an asset as its price falls, resulting in a lower overall average purchase price. It is sometimes known as buying the dip. Adding to a position when the price drops, or buying the dips, can be profitable during secular bull markets.
When should I average down? ›
Averaging down is only effective if the stock eventually rebounds because it has the effect of magnifying gains; if the stock continues to decline, averaging down has the effect of magnifying losses.
What is averaging 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.
What is an example of averaging down? ›
Averaging down example
Let's say you buy 100 shares of XYZ at $45.00 per share, and the stock plummets to $30.00 per share in price. If you buy another 100 shares of stock at $30 each, your average purchase price would be $37.50.
What are the risks of averaging down? ›
Averaging down, as the name implies, lowers the average the trader paid for the asset. This reduces the price at which the investment could potentially return a profit – provided, of course, that the price bounces back. There is the risk that the price will continue to fall and leave investors with an even bigger loss.
What is the benefit of averaging down? ›
Averaging down can get a trade back to breakeven or into profit quicker than if the strategy wasn't used, assuming the stock price rises after adding to the position. If the stock price rises after averaging down, large profits are possible since additional shares were purchased at a lower price.
Is it better to average up or down? ›
Averaging down works best when you are confident that an investment is a long-run winner. As such, buying the dips will have you accumulating your position at progressively better prices, making your ultimate profit potential greater.
How much stock do I need to buy to average down? ›
Example of Averaging Down
Consider this example: Imagine you've purchased 100 shares of stock for $70 per share ($7,000 total). Then, the value of the stock falls to $35 per share, a 50% drop. To average down, you'd purchase 100 shares of the same stock at $35 per share ($3,500).
What is the strategy of averaging? ›
Dollar cost averaging is a strategy to manage price risk when you're buying stocks, exchange-traded funds (ETFs) or mutual funds. Instead of purchasing shares at a single price point, with dollar cost averaging you buy in smaller amounts at regular intervals, regardless of price.
Should you buy more stocks when they are down? ›
It's a buying opportunity. Market downturns can be scary — but they also mean financial assets like stocks are on sale. "If you are financially able, down markets provide an excellent opportunity to buy into your existing or new investments at generally lower levels," Sowhangar says.
Averaging up can be an attractive strategy to take advantage of momentum in a rising market or where an investor believes a stock's price will rise. The view could be based on the triggering of a specific catalyst or on fundamentals.
What is averaging down during a recession? ›
Dollar-cost averaging is an investing strategy where you buy a fixed amount of an investment on a regular basis, regardless of the current price. Recessions are great opportunities to use a dollar-cost averaging approach because you'll buy shares as the price declines.
Why may averaging down result in poor investment decisions? ›
Averaging down stocks ignores investment quality.
It's true that good stocks can drop and stay down for lengthy periods. But bad stocks are more likely to go down and stay down. If you routinely buy more of any stock you own that goes down, you run the risk of loading up on your worst choices. That costs you money.
Why is averaging averages bad? ›
Attempting to average existing averages without knowing the number of values contained in each value leads to statistical errors. Either use the original values or keep hold of the number of values included in the average in order to keep your numbers accurate.
How do you calculate averaging down? ›
The formula for averaging down for any investment is to divide the total cost of your position by the number of shares or units you hold.
What are the disadvantages of dollar-cost averaging down? ›
Cons of Dollar Cost Averaging
This is based on the idea that the longer you have your money in the market, the better your returns are over the long run. More fees. Dollar cost averaging also means making more transactions, which can result in higher brokerage fees.
Can you break even by averaging down? ›
The equation explains that investors can break even or book profits more quickly by using an average down strategy than they would otherwise. Thus, when stock prices rise average down approach will earn large profits for the investor as the investor purchases additional shares at a lower price.
How much do I need to buy to average down? ›
Example of Averaging Down
Consider this example: Imagine you've purchased 100 shares of stock for $70 per share ($7,000 total). Then, the value of the stock falls to $35 per share, a 50% drop. To average down, you'd purchase 100 shares of the same stock at $35 per share ($3,500).
Is it OK to take an average of averages? ›
Summary. Attempting to average existing averages without knowing the number of values contained in each value leads to statistical errors. Either use the original values or keep hold of the number of values included in the average in order to keep your numbers accurate.
How do you calculate average down? ›
The formula for averaging down for any investment is to divide the total cost of your position by the number of shares or units you hold.
