In the stock market, every price movement is an opportunity, be it during a bull or bear run. Short-term fluctuations in share prices can be an opportunity for an investor to average down his investment costs to minimise losses or make higher profits than when he set out originally.
Table of Contents
- What Does Average Down Mean?
- Example of Averaging Down
- When to Average Down as an Investment Strategy?
- Pros and Cons of Averaging Down
- Frequently Asked Questions
What Does Average Down Mean?
Averaging down is an investment strategy where you buy more assets such as equity shares when their prices drop. This brings your average cost per share down. The strategy resembles dollar-cost averaging. Buying more shares after the price drops will reduce your breakeven price. However, your risk exposure also increases, as you now own more shares.
If the stock price moves up after you have purchased the additional shares, your profit will increase as your average price has been lowered. But if the share price goes down further, your original loss will widen.
Example of Averaging Down
Suppose an investor holds 10 shares of Company XYZ, whose share price has gone down from US$50/share to US$45/share. His loss is US$5/share if he sells his shares.
However, he believes that the market is unduly pessimistic about the company and that the share price will recover eventually. He snaps up 10 more shares at US$45/share.
His paper loss = 50 – {(10*50 + 10*45) / 20} = 50 – 47.5 = US$2.50/share.
This is lower than his original potential loss of US$5/share.
When to Average Down as an Investment Strategy?
If you are a long-term investor and your original reason for liking and buying a stock still applies, it makes sense to accumulate its shares.
However, if something fundamental has changed about that company, such as a loss of market share to competitors or slowing sales growth, averaging down may not be a good idea as you could be throwing good money after bad.
Pros and Cons of Averaging Down
The most notable advantage of averaging down is lowering your average cost of investment. 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. By averaging down, you’re also increasing the size of your investment. So if the share price continues to fall, your losses will become greater than your original position.
Frequently Asked Questions
How do I calculate my average cost price after averaging down?
Average cost price = (Sum of prices of all my shares) / (Total number of shares)
Lump-sum investing versus average down: which is better?
In lump-sum investing, you invest a big sum of money into an asset. You gain exposure to that asset immediately. When markets are on an uptrend, putting your money to work right away helps you take full advantage of price growth.
In averaging down, you buy more stocks when prices are falling. Averaging down may be appropriate when you want to minimise the downside risk from a huge investment or take advantage of the market’s naturalvolatility to lower your average price.
https://investor.vanguard.com/investing/online-trading/invest-lump-sum
Does averaging down mean I can’t “buy low and sell high”?
No, the whole idea behind averaging down is to buy low and sell high i.e. buy more shares in a bearish market at a low price and sell them in a bullish market at a higher price.
