Averaging Down definition
A strategy for purchasing supplementary quantities of shares owned when the price falls to decrease their average cost
What is Averaging Down?
Averaging down or average down includes the purchase of additional quantities of stocks owned by the investor after a decrease in stock price. With the strategy, investors are able to decrease the cost per share. Hence, the needed price increase for a positive return is lower after performing average down.
As attractive as this strategy may look, it comes with the uncertainty about the price movements. Investors should estimate the possibility that the price will bounce back instead of decline even further.
Averaging Down explained
Reducing the average cost of shares can generate profits with a smaller price increase. Although the strategy comes with a certain risk, the idea is that the investors have identified a long-term potential in the specific stock, prior to buying the initial shares. Hence, any current price decrease should be utilised for averaging down the price, because in the future, the price will continue to increase. Expectations for a future price increase make this strategy adequate for long-term investors.
For example, an investor already owns 100 shares of company A purchased at $20 per share with a total value of $2,000. The market price of this share has declined down to $10 per share. The investor buys an additional 100 shares at a price of $10 for a total of $1,000. Now the investor owns 200 shares of company A purchased for a total amount of $3,000. With the purchase of additional shares, the average price per share paid by the investors is now $15, $3,000 divided by 200 shares. The investor doesn't have to wait for the share price to increase above $20 to make a profit. The investors decrease the average share price down to $15, and they make a profit when the price goes above the average price.
Pitfalls of average down
Although it looks like a lucrative strategy, averaging down has certain pitfalls. The price may continue to decrease and the investor can end up with a substantial loss if the price doesn't bounce. If you constantly buy multiple quantities of the same share, it may disbalance your portfolio. Moreover, executing multiple purchases adds up the transaction costs because each trade has a fee.