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.
Averaging down is considered to be a value-oriented investing strategy.
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.
What is averaging down? ›
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.
How do you average down properly? ›
Here's how it works. In a typical averaging-down situation, you buy 100 shares at $50 per share, then the stock drops to $49 per share. So you buy another 100 shares at $49 per share, which lowers your average price to $49.50 per share.
How does averaging help? ›
In a bull market, averaging lowers the cost of newly bought units. Nonetheless, in a bear market, averaging lowers losses as the average purchase price decreases. The principle that revolves around the averaging concept is purchasing a specific asset multiple times but at different prices.
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.
When should I average down? ›
When might an investor employ this strategy? Longer-term investing strategies generally benefit the most from averaging down. This is because of the long-term investment horizon on trades and mostly applies to stock index funds, as these tend to rise over time. For any single stock, that may not hold true.
Why is averaging down good? ›
Pros of averaging down
Increased potential gains: Value investors have long known that buying the dip can yield increased potential for gains, given enough time. By doubling down and increasing your exposure, you also raise your potential profit if the price rebounds.
How to avoid averaging down? ›
Instead of averaging down, or even scaling in, a popular option is to choose an entry point and then place a stop loss to exit the trade at a small loss if the price doesn't move as expected.
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.
Do you buy stocks when they are red or green? ›
On many tickers, colors are also used to indicate how the stock is trading. Here is the color scheme most platforms use: Green indicates the stock is trading higher than the previous day's close. Red indicates the stock is trading lower than the previous day's close.
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).
At what price should I buy a stock? ›
When the price of shares are low, you must buy the shares. Of course, there's a chance that prices will dip further. However, this is a safer bet than buying at high prices when the stock seems unlikely to climb further in value.
Do you owe money if a stock goes negative? ›
No. 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.
What is a risk of averaging down? ›
Averaging down is a risky investment strategy that can lead to significant financial losses and become a permanent money-losing disaster. Essentially, it involves investing more money into a losing investment.
Why averaging is bad? ›
Show Me the Number
But whenever an average is used to represent an uncertain quantity, it ends up distorting the results because it ignores the impact of the inevitable variations. Averages routinely gum up accounting, investments, sales, production planning, even weather forecasting.
Should I sell a stock at a loss? ›
An investor may also continue to hold if the stock pays a healthy dividend. Generally, though, if the stock breaks a technical marker or the company is not performing well, it is better to sell at a small loss than to let the position tie up your money and potentially fall even further.
Is it better to average up or average down? ›
Averaging down is often favored by investors who have a long-term investment horizon and who adopt a contrarian approach to investing, which means they often go against prevailing investment trends.
What happens when you average down on a stock? ›
Average down refers to an investor's approach while investing in stocks or shares to maintain a sustainable portfolio. Under this approach, an investor buys additional shares or doubles the number of shares purchased previously in their stock to decrease the average purchase price of the investor.
