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? ›
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.
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.
Should I keep averaging down stocks? ›
Averaging down can result in large losses if the stock doesn't bounce and keeps dropping. Adding to a position as it declines may mean the trader doesn't have a sound risk-management method, such as using a stop-loss order or exiting when the stock falls by a certain amount.
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.
How does averaging works? ›
It is carried out by acquiring more shares after there is a fall in the share price following its initial purchase. Buying more shares means the average cost of all shares held is lowered, and this leads to the breakeven point lowering as well.
Is averaging a good strategy? ›
Averaging Up
This strategy can be useful when the trader is confident that the price will continue to rise in the future. For example, suppose A has a bullish view on XYZ stock and buys 100 shares at ₹1,660. After a few days, the price rises and A buys 100 more shares at ₹1,960 and another 100 shares at ₹2,250.
How many stocks 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).
How to work out averaging down? ›
For example, let's suppose that an investor initially paid £110 per share. If the price falls to £100 per share, the investor might choose to buy the same number of shares they initially did in order to average down the price they paid per share to £105. This is achieved by (110 + 100) /2.
When should I average my stocks? ›
Averaging is beneficial in both rising and falling markets. Averaging helps you accumulate more profits, if you buy stocks in rising markets. Similarly, in declining markets, it aids in lowering the average purchase price. In selling, it helps you to earn more average profits in case of rising markets.
A good rule of thumb that most investors live by is to cut losses anytime a stock falls 5-8% below the price you purchased it at. The most important thing to remember is that the earlier you accept a loss, the more money you'll save in the long run.
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.
What is the average down rule? ›
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.
What is a good amount of shares to buy? ›
Deciding How Many Shares to Buy
There is no minimum amount of shares you must purchase when buying stocks, however, considering broker commissions and fees, most people are best off buying a minimum of $500-1000 worth of shares when investing.
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.
Is averaging down a good idea? ›
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.
What are averaging techniques in stock market? ›
Averaging in the stock market refers to a trading strategy aimed at mitigating market volatility by adjusting share prices either upward or downward. This method involves several techniques, such as the pyramid technique, average up, and average down, which can be employed based on market conditions.
What is the formula for stock averaging? ›
To find the stock average, add the total cost of all stock transactions and divide by the total number of shares purchased. This calculates the weighted average price per share. Alternatively, use the formula (Opening Stock + Closing Stock) / 2 for inventory, calculating average stock levels throughout time.
Should you buy stocks when they are down? ›
It works the same way with investing in stocks. If you believe a stock is a good long-term investment, you should invest in it regularly. If the price goes down, don't look at it as a bad thing. Look at it as an opportunity to get more for your money.
Why does averaging work? ›
When dollar-cost averaging, you invest the same amount at regular intervals and by doing so, hopefully lower your average purchase price. You will already be in the market when prices drop and when they rise. For instance, you'll have exposure to dips when they happen and don't have to try to time them.
When a trader purchases an asset, the asset's price drops, and if the trader purchases more, it is referred to as averaging down. It is called averaging down because the average cost of the asset or financial instrument has been lowered.
What is averaging down in Crypto? ›
What Does It Mean to Average Down? The concept of Averaging down is a principle of buying sequential quantities of a currency pair or an asset as the price is falling, which eventually leads to a lower average entry price.
What is averaging down swing trading? ›
Averaging down is adding to a position as the trade loses money. The logic is that buying at lower prices reduces the average price of the position. This increases the gain if the price goes back up, or gets the trader back to break even quicker.
What is averaging down martingale? ›
Averaging down is a strategy of avoiding losses rather than seeking profits. The Martingale-strategy averaging down can be implemented through a series of closed positions that have gone against you, or by doubling down within an open position.
