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.
How to calculate average down? ›
The investor or trader still likes the stock and, therefore, decides to buy another 100 shares at a lower price. 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 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 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.
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.
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.
How to dollar cost average 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). Now, you'd own 200 shares for a total investment of $10,500.
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 is the wash sale rule? ›
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
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.
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.
When should you sell a stock? ›
Occasionally, markets can get overly optimistic about the future prospects for a business, bidding its stock price to unsustainable levels. When the price of a stock reaches a level that cannot be justified by even the best estimates of future business performance, it could be a good time to sell your shares.
When should I average down? ›
Averaging down can be an effective strategy if you believe that the stock's current price does not reflect its true value. However, this strategy should not be used blindly, as it can lead to significant losses if the stock's fundamentals do not improve.
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.
Should I 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.
What is the formula for average decline? ›
You subtract the current year's number from the previous year's, divide the result by last year's number, and multiply by 100. If negative, the result is the percentage that metric declined for the year. A positive number reflects an increase.
How do you calculate average using reduce? ›
Using reduce() method
The approach sums array elements with reduce(), divides by array length for average. Utilizes reduce's accumulator to compute total sum, then divides by array length to derive average value.
How do you bring an average down? ›
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.
