Averaging Down

What is Averaging Down?

Averaging down refers to the practice of buying additional shares of a stock after it has declined in price from your original purchase price. The goal is to lower your overall cost basis or average price paid per share.

For example, if you bought 100 shares of XYZ at $100, and it drops to $80, you could buy another 100 shares at $80. This would bring your total cost basis down from $100 to $90 per share on the 200 share position. It’s a way to potentially benefit more if the stock eventually recovers by getting shares at lower prices.

Pros and Benefits of Averaging Down

A major advantage of averaging down is that it lowers your break-even point for the investment. With a lower cost basis, you don’t need as significant of a rebound to make a profit.

It also allows you to accumulate more shares if you still believe in the long-term prospects. Advocates argue it instills a disciplined approach of sticking to your strategy instead of panic-selling on short-term volatility. However, benefits hinge on being right about the recovery case.

Risks and Drawbacks of Averaging Down

The biggest risk of averaging down is “catching a falling knife” by continually adding to a losing position that keeps declining further.

There’s a possibility you are wrong about the reasons for the drop and end up tying up even more capital in a fundamentally flawed investment. This violates the prime directive of not throwing good money after bad. Averaging down too aggressively can also deplete your cash reserves needed for other opportunities.

Strategies for Prudent Averaging Down

To mitigate some of the risks, experts advise prudent averaging down strategies. Only do so with high-quality companies facing temporary setbacks, not failing businesses.

Predetermine a strict maximum amount in $ or % of portfolio you’ll average down to avoid overexposure. Laddering smaller incremental buys instead of one big purchase can also make sense.

When to Consider Averaging Down

Averaging down may be appropriate when the company’s core fundamentals and growth potential still look strong, and the stock seems to be declining due to a short-term issue or broad market overreaction.

If your long-term investment thesis is intact, then it could present a buying opportunity. However, you need to objectively re-evaluate the reasons for the drop and whether the negative factors are indeed temporary.

Alternatives to Averaging Down

While averaging down aims to lower your cost basis, an alternative approach is to simply cut your losses and sell the original position if the reasons for owning the stock no longer apply.

You could then re-deploy that capital into other investments with more potential. Or wait for clear signs of a reversal and uptrend before re-entering the position instead of trying to catch a falling knife. Diversification across uncorrelated assets is also wise.

Alexander Voigt, CEO
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Alexander Voigt is the founder of DayTradingZ, was a regular contributor to Benzinga and has been featured and quoted on leading financial websites such as Investors.com, Capital.com, Business Insider and Forbes.