Averaging Down

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.

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