What Is Average Down?
Averaging down, also known as "dollar-cost averaging down," is an investment strategy where an investor purchases additional security shares at a lower price than their initial purchase price. This strategy is employed when the investor believes that the asset's current price is below its intrinsic value or that it will rebound in the future.
In essence, averaging down aims to reduce the average cost per share of an investment. This is typically done by buying more shares when the asset's price has fallen. The goal is to lower the overall break-even point for the investment.
Also Read: Why Investing Is Important: Don’t Let Your Savings Sit Idle
Key Takeaways
- Average down means buying more of a stock at a lower price.
- Benefits include risk reduction, improved returns, and long-term wealth.
- Risks involve catching falling assets, sunk cost fallacy, and opportunity cost.
- Steps for averaging down include research, fundamental analysis, risk management, and patience.
Terms that you need to know
DCA: It is the process of buying a security with an equal amount of money at regular time intervals.
Time Horizon: It is the time after which you want to sell your investments and get your money.
Asset Class: Stocks, bonds, real estate, and commodities are some examples of asset classes. An asset class is a term used to classify a similar group of investments.
How to Invest with Averaging Down?
Investing with averaging down is a strategy where you buy additional shares of an investment at a lower price than your initial purchase to reduce your overall cost basis. This can be an effective strategy in some situations, but it also carries risks. Here are the steps to invest with averaging down:
Do Your Research
Before you start investing, it's crucial to research the asset or investment you're interested in. Understand the fundamentals, historical performance, and any potential catalysts that could impact its price.
Set Investment Goals:
Determine your investment goals, risk tolerance, and time horizon. Averaging down can be a long-term strategy, so make sure it aligns with your financial objectives.
Initial Purchase:
Begin by making your initial purchase of the asset at a price you believe is a good entry point. This should be based on your analysis and the investment's current market conditions.
Monitor the Investment:
After your initial purchase, closely monitor the performance of your investment. Pay attention to news and events that may impact its price. Be prepared to adjust your strategy if necessary.
Identify a Lower Price Entry Point:
To average down, you'll want to identify a lower price at which you'd be comfortable buying more of the asset. This lower price should ideally be based on a reasoned analysis of market conditions and the investment's fundamentals.
Allocate Additional Funds:
If the asset's price drops to your identified lower price entry point and you still have confidence in its long-term potential, allocate additional funds to purchase more shares. It's important to use money you can afford to invest and not risk more than you can afford to lose.
Calculate Your New Cost Basis:
After making the additional purchase, calculate your new cost basis. This is the average price you paid for all of your shares. It's calculated by adding the cost of your initial purchase to the cost of your new purchase and then dividing it by the total number of shares.
Continue Monitoring:
Continue to monitor the investment's performance and adjust your strategy as needed. If the price continues to decline, you may consider averaging down further if you have the resources and conviction.
Set Exit Criteria:
It's important to establish clear exit criteria. Determine at what point you would sell the investment, whether for a profit or to limit losses. Having a plan in place can help you avoid emotional decision-making.
Diversify Your Portfolio:
While averaging down can be a useful strategy, it's essential to maintain a diversified portfolio to spread risk. Don't put all your funds into a single investment or asset class.
Also Read: Asset Allocation: Definition, Importance, and Strategies
Seek Professional Advice:
If you're new to investing or unsure about your strategy, consider seeking advice from a financial advisor or investment professional.
Benefits of Averaging Down
Lowering the Average Cost Basis:
The primary benefit of averaging down is that it reduces your overall cost basis for an investment. By purchasing additional shares at a lower price, you effectively lower the average price you paid for all of your shares. This can make it easier to achieve a profitable exit when the asset's price rebounds.
Increased Profit Potential:
Averaging down can enhance your profit potential when the investment eventually recovers. If the asset's price goes up, your gains will be larger because you acquired more shares at a lower cost.
Enhanced Long-Term Returns:
If you have a strong conviction that the investment will perform well over the long term but is temporarily undervalued, averaging down can lead to better long-term returns. It allows you to accumulate more of the asset at a favorable price.
Reduced Losses:
In some cases, averaging down can help mitigate losses. If you originally purchased an asset at a higher price and it subsequently drops, buying more at a lower price can reduce the percentage loss on your overall investment.
Strengthened Confidence:
Averaging down can boost your confidence in your investment thesis. If you believe in the fundamentals of the asset and it continues to be undervalued, buying more at a lower price can reinforce your conviction.
Risks and Challenges of Averaging Down
While averaging down offers several benefits, it is not without risks and challenges:
Market Risk:
The most significant risk of averaging down is that the asset's price may continue to decline. Just because an investment has dropped in price doesn't guarantee it will eventually recover. If the asset's fundamentals deteriorate or if there are systemic market issues, your losses could mount as you continue to buy more shares at lower prices.
Loss Magnification:
Averaging down can potentially magnify your losses if the investment continues to perform poorly. By buying more shares at lower prices, you increase your exposure to the asset, and if it doesn't recover, your losses will be larger in absolute terms.
Opportunity Cost:
The funds you allocate to average down in one investment could be used elsewhere in potentially more profitable opportunities. There's an opportunity cost associated with tying up your capital in a declining asset rather than diversifying or investing in other assets that may perform better.
Psychological Stress:
Averaging down can be emotionally challenging. Watching an investment's value decline can cause anxiety and stress. It may be difficult to remain disciplined and stick to your strategy if the asset's price continues to drop.
Lack of Conviction:
Sometimes investors average down without a strong fundamental reason to do so. If you don't have a clear thesis for why the investment will rebound, you may be throwing good money after bad.
Example of Averaging Down
Let's say you're an investor who bought 100 shares of Company XYZ at $50 per share because you believed the stock had strong growth potential. However, after a few months, unexpected market conditions and negative news about the company's industry caused the stock price to drop significantly.
- Original Purchase: 100 shares of Company XYZ at $50 per share
- Total Investment: $5,000
However, you still have faith in Company XYZ and its long-term prospects. You decide to use the averaging down strategy to lower your average cost per share. You purchase an additional 100 shares when the stock price drops to $40 per share.
- Additional Purchase: 100 shares of Company XYZ at $40 per share
- Total Investment (additional purchase): $4,000
Now, you own a total of 200 shares of Company XYZ, with an average cost per share calculated as follows:
- Total Investment (original purchase + additional purchase): $5,000 + $4,000 = $9,000
- Total Number of Shares: 200
- Average Cost per Share: $9,000 / 200 shares = $45 per share
By averaging down, your average cost per share has decreased from the initial $50 to $45 per share. This means that to break even or make a profit, the stock price only needs to rise to $45 per share instead of the original $50 per share.
Conclusion
Averaging down is an investment strategy that involves buying more shares of a stock that you already own when its price drops. Averaging down can help you lower your average cost and breakeven point, increase your profit potential, and express confidence in your investment. However, averaging down can also increase your exposure and risk, compound your losses, and impair your judgment. Therefore, it is important to use averaging down wisely and follow some guidelines.
