Averaging Down Stocks: Everything You Need to Know

In order to average down, an investor purchases additional shares when a stock's price drops. Find out whether it is a good practice or a risk. In secular bull markets, adding a position when the price drops or buying during a downtrend can be profitable, but it can compound losses in secular bear markets.

If the value of a stock you own declines, you may wonder what to do. If you sell the stock and accept the loss, you can do nothing and hope that the stock's value will increase, or you can buy additional shares while it is still low. You can also increase your stock holding at a discount by using the third, averaging down strategy. If those shares eventually rise in value, averaging down could be worth it, but it's imperative that you understand the risks and how the process works. A financial advisor can help you consider relevant factors before making a buy-and-sell decision.

As investors build up their portfolios, they sometimes use a strategy known as "averaging down stock." 

This strategy involves buying more shares of a stock they already own after declining value. A reduction in the average stock price in an investor's portfolio results from purchasing more of the same stock at a lower price. Our discussion will focus on the pros and cons of averaging down and when it might be a good time to implement this investment strategy. Averaging down refers to the process by which additional funds are invested in a financial instrument or asset if its value decreases significantly after the original investment. Although this can lower the average cost of tools and assets, the returns may not be as strong. It might result in an investor having a larger share of a losing investment, which does not seem to be a popular strategy among investors and traders. Average down has the main advantage of lowering the average cost of a stock holding significantly. The stock could turn around, which would mean a lower breakeven point for the position and higher dollar gains.

What is Averaging Down in stocks?

When the price of a stock drops, average down is a technique used to buy additional shares. In other words, when you buy more shares of an already owned stock for a lower price, it lowers the average cost per share of what you own. The underlying principle of a dollar-cost averaging strategy is this—dollar-cost averaging means investing regularly regardless of what stock prices are doing. In theory, your returns will be more or less equal if you invest continuously over different market cycles. As opposed to averaging up, averaging down means averaging down. When your average is up, you're buying more shares of stock as their value rises. It raises the average cost per share of what you own.

• If a financial instrument or asset decreases significantly in price after the initial investment, averaging down involves investing additional amounts in it.

• Averaging down is often favoured by investors with a long-term investment horizon and disregarding market trends, which means they are often contrarians.

• Averaging down trading strategy is only effective if the stock eventually rebounds because it has the effect of magnifying gains; if stock continues to decline, averaging down has the effect of magnifying losses.

• Averaging down is best restricted to blue-chip stocks that satisfy stringent selection criteria, such as a long-term track record, minimal debt, and solid cash flows.

Example of Averaging Down

As an example, suppose that a long-term investor owns the stock of Widget Co. and is optimistic about the future. An investor who holds this viewpoint may consider a sudden decline in Widget Co.'s stock a buying opportunity and perhaps perceive other investors to be overly pessimistic about the company's long-term prospects. As a result of adopting an averaging down strategy, an investor might view a stock whose price has declined as offering a discount to its intrinsic or fundamental value.

On the other hand, a stock decline is more likely to indicate the stock's potential performance in the future for investors and traders with shorter-term investment horizons. Investors who favor trading in the current trend direction are more likely to do so. They rely more on technical indicators, such as price momentum, to justify their investing decisions. Using the example of Widget Co. stocks, a short-term trader who initially bought the stock at $50 may place a stop-loss order of $45. When Widget Co.'s stock trades below $45, the trader will liquidate his position.

How to Calculate Averaging Down in Stocks?

Investing or trading in the stock market requires averaging the stock's price to minimize the massive losses. If the investor bought the stock at a different price, with other costs, and other shares, then the average down calculator can calculate the stock's average price. This tool added every share purchased at a different price, divided by the total cost. Finally, the user received an average of the stock price. When you purchase the same stock multiple times, the stock average calculator calculates the average cost of your investment. Use the average down cost calculator to estimate your average up cost. Separate each transaction if you bought a stock multiple times. There is no way to determine a breakeven point when you average down. Ultimately, the strategy is effective only if the stock price rises again. The longer it falls, the more money you'll lose, and the sooner you stop it, the better.

By averaging down the stock, you can purchase more shares at a lower price than the previous price, which results in lower shares costs if the process is repeated. Holding stocks for price rises can produce a more significant profit than a slight upward move in share price. A price range can be visualized as an average price in basic mathematics. To calculate it, add up the total cost spent and divide that by the number of shares. By comparing the current price with previous prices, an average price can determine whether the stock's value exceeded expectations. If there is a range of prices, you can use the Average down Calculator to reduce the range to one price by calculating the average cost. Investors and traders want to know the average price when they buy shares at different prices, and then they decide that the stock is a profitable purchase.

How to Execute Averaging Down?

One of the world's most savvy investors, Warren Buffett is an excellent example of averaging down. Considering these recommendations, averaging down may be a good strategy for averaging.

Take into account the timing

The strategy may be advantageous during periods of panic and fear on the markets since panic liquidations may result in the availability of high-quality stocks at a compelling price. In 2002, some of the most extensive technology stocks were trading at bargain levels. In contrast, in the second half of 2008, the U.S. and international bank stocks were on sale3 The key is to be prudent in evaluating which stocks will survive the shakeout. 

Analyze the fundamentals of the company

It is essential to evaluate a company's fundamentals before averaging down a position. A stock decline may be a symptom of a longer-term malaise or just a temporary phenomenon. These three factors need to be assessed at a minimum: the firm's competitive position, its long-term earnings outlook, and its capital structure.

Blue-chip stocks are exempt from restricted averaging

Rather than a catch-all strategy that applies to every stock in the portfolio, averaging down should be used selectively. Investing in high-quality stocks with a low bankruptcy risk is best to average down. For example, a well-established company with a long track record, a solid competitive position, very little or no debt, produces good cash flow, is stable, and has sound management may be an excellent candidate to be averaged down.

Let's consider the following example: Suppose an investor purchased 100 shares of stock for 70 cents each. The stock drops in value to $60. The investor purchases 100 more shares at $60 apiece in order to average down. In the end, the investor owns 200 shares: half were purchased for 70 dollars apiece, and a half for 60 dollars apiece. Therefore, the average purchase price was $65. By lowering their average purchase price, the investor has effectively averaged down.

Averaging down comes with risk, as with any strategy. A person who buys more of the stock at a lower price after averaging down will have made a good decision if the stock price goes up after averaging down. An investor who doubles down on a losing investment would mean that prices decline.

The main benefit of buying low and selling high is that you will reap substantial gains if you buy low and sell high later on. The trick is to differentiate between stocks that are experiencing a short-term decline versus stocks that are stuck in a steady downward trend. Buying at a discount is another strategy to consider. As with value investing, spotting a value trap is similar to that method. By taking a value investing approach, you will find stocks undervalued by the market and are otherwise likely to grow significantly in the future. However, a value trap occurs when a company appears undervalued but is overvalued. When you learn fundamental analysis and technical indicators, you can identify which investments would make good average-down targets. Share prices for a company going through a restructuring may temporarily decline but recover if its financials (revenue, profit, debt levels, etc.) are otherwise strong. Averaging downplay could put you ahead. If the stock price starts climbing again after the reorganization is complete, an averaging downplay could put you ahead. When determining whether it makes sense to try and average down a stock, some simple calculations can help decide whether or not it makes sense to do so.

How to Invest with Averaging Down?

If you are interested in averaging down stocks in your portfolio, speak with a financial advisor about dollar-cost averaging. Finding a financial advisor doesn't have to be difficult if you don't have one. Connecting to professional advisors online is easy with the financial advisor matching tool. You can get personalized recommendations for financial advisors in your local area using the tool. A good asset allocation calculator is an essential tool for investors, ensuring a portfolio maintains the right balance between different asset classes. If you're comfortable with the risks, the following tips can help you implement an average-down strategy in your portfolio.

Do your research

Before attempting to average down a company's price, it's essential to check its fundamentals to understand how financially secure it is. This information makes it possible to differentiate short-term price drops from long-term downward trends.

Check market conditions

Be sure to examine the larger market and what may be causing a company's price to fall. We can gauge the probability of current pricing trends continuing by looking at the market cycle and what may be causing volatility.

Set limits

With averaging down, you can minimize your loss potential by selecting an exit point or a point where you will not purchase additional shares. You can avoid losing more money if you put these kinds of limits in place. 

Advantages of Averaging Down Stocks

Averaging down enables one to buy stocks at a lower price than one had previously paid is the primary benefit of averaging down. A long-term investment decision should be based as much on the desire to own stock as on the recent price movements. Recently changed prices are only one part of an analyst's stock analysis.

Investors who feel committed to its growth and believe the stock will continue to do well for a more extended timeframe may be able to justify the purchase. It will have been a success if the stock ultimately turns positive and experiences solid growth over time.

Besides encouraging investors to invest more, this approach may also encourage them to commit more money to their portfolio, which is a positive factor in and of itself. A strategy is nothing without the work it takes to implement it.

Last but not least, the averaging down strategy could tap into an investor's "buy low, sell high" mentality. Any investment strategy is designed to create an income stream or sell the product later at a higher price. Thus, investors should prefer to pay a lower price rather than a higher one.

Disadvantages of Averaging Down

The averaging down strategy requires an investor to purchase a stock that is losing value at the moment. Also, it is always possible that this fall is not temporary and is the beginning of a more considerable decline in the company and its stock value. In this case, an investor who averages down may have just increased their holding in a losing investment.

Price change should not be an investor's only indication to purchase stock. If an investor plans to average down, they should do their research before buying, but even so, predicting a stock's trajectory can be difficult because short-term price changes can be influenced by investor demand and sentiment, which are notoriously difficult to predict. The process would require knowing the needs of millions of investors worldwide, including institutional investors, will be tomorrow, next month, or even a few years.

That is all connected to the reality that picking individual stocks, in general, is difficult. On average, the stock does not outperform its index. When you factor in how hard it is to know when to buy and when to sell stocks, it could be a recipe for heartbreak.

The Bottom Line

A viable strategy is to invest in stocks, exchange-traded funds, and mutual funds by averaging down. Investors should be careful when choosing which positions to average down. A blue-chip stock is selected to meet stringent selection criteria, including a long-term track record, low debt, and strong cash flows. Consider your risk tolerance and take a slight loss before it becomes a significant loss. You can then move on to the subsequent investment.

Averaging down may make sense if you are looking for long-term investments. As long as you are convinced of the company's fundamental strength, you can accumulate more shares at a lower price. With a lower average price, you could end up with more shares and make a profit.

It makes sense for investors interested in averaging down to research the company and the stock as possible. It's not enough to go with intuition and expect that stock prices will rise after you buy low. Furthermore, it's a common misconception that investors must buy individual stocks to succeed. However, there are easier ways to invest that can be more successful in the long term, such as a buy-and-hold index fund strategy.