Averaging Down is an investment strategy where an investor buys additional shares of a stock as its price declines. This action reduces the average cost per share of the total position. By purchasing more shares at a lower price, the investor lowers the overall average cost of the entire investment, making it easier to achieve a profitable exit once the stock price starts to rise again.
How Averaging Down Works
Calculation of Average Cost
The formula for calculating the new average cost per share after averaging down is as follows:
Example
Suppose an investor initially buys 100 shares of a stock at $10 each. The stock price then drops to $8, and the investor buys another 100 shares. Here’s the calculation:
- Initial Investment: 100 shares * $10 = $1000
- Additional Investment: 100 shares * $8 = $800
- Total Investment: $1000 + $800 = $1800
- Total Shares: 100 + 100 = 200
New Average Cost Per Share:
Types of Averaging Down Strategies
Lump Sum Averaging Down
In this strategy, investors buy a significant number of shares in one purchase to lower the average cost. This approach is riskier as it requires more capital upfront.
Scale Orders
Scale Orders involve placing several buy orders at lower price levels systematically. This structured approach helps manage risk by spreading out the purchases.
Special Considerations
Risk Management
While averaging down can be an effective strategy in a recovering market, it involves significant risk. If the stock continues to decline, the investor may face substantial losses.
Suitable Conditions
Averaging down may be ideal for:
- High conviction holdings where the fundamentals indicate a temporary price decline.
- Stocks with strong historical performance but facing short-term setbacks.
Psychological Factors
The decision to average down often requires strong conviction and confidence in the underlying asset, as it can be psychologically challenging to invest more in a declining asset.
Historical Context
Although the concept of averaging down has been prevalent for centuries, it gained popularity in the 20th century with the growth of the stock market and the availability of capital for retail investors.
Practical Applications
Example in Real-world Investing
Many well-known investors, such as Warren Buffett, have employed averaging down strategies when they believe in the long-term value of a stock despite short-term price declines.
Comparison with Other Strategies
Averaging Up
Unlike averaging down, averaging up involves buying more shares as the stock price rises. This strategy can ensure you’re adding to a winning position, in contrast to averaging down’s potential pitfall of adding to a losing position.
Dollar-Cost Averaging
Dollar-cost averaging involves investing equal amounts regularly, regardless of the stock price. This strategy reduces the risk of poor timing and spreads out the investment over time.
Related Terms
- Dollar-Cost Averaging: Investing equal amounts of money at regular intervals in a particular security, reducing the impact of volatility.
- Breaking Even: The point at which total costs and total revenue are equal, resulting in no net loss or gain.
FAQs
Is Averaging Down a good strategy?
What are the risks involved?
How do I decide whether to average down on a stock?
References
- Graham, Benjamin. The Intelligent Investor. Collins Business Essentials, 2006.
- Malkiel, Burton G. A Random Walk Down Wall Street. W.W. Norton & Company, 2019.
- Damodaran, Aswath. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley, 2012.
Summary
Averaging down is a nuanced strategy that can lower the average cost per share in a declining market. While practiced by renowned investors, it requires a well-thought-out approach and awareness of potential risks. Suitable for high-conviction investments, it should be pursued with caution and thorough analysis.
