Averaging down is a time-honored investing tradition. It is when a stock you have picked has dropped 10-20%, at which point you decide to “average down” by buying more shares. The idea is that your cost basis is now lower, so when the stock shoots back up you’ll be in good shape.
While this sounds good on paper, often we average down just because we can’t admit that we picked a lemon. We think, “Gee, I thought it was good at the original price — now it’s really a bargain. ” Our pride keeps us from taking a loss, instead putting more good money after bad, and ending up with a portfolio full of losers, having sold all of our winners when they gained 10%. Often, having held a loser for a long time, we sell if it returns to the original purchase price because now we are “breaking even”. This is usually the point at which the stock goes through the roof to new highs.
In general, when I am buying a stock, I plan ahead of time to dip my toes in, and then buy on price dips until I’ve accumulated a sufficiently large position. This may involve averaging down (unless it is moving up, such that the dips are progressively higher), but this is part of the plan. I’m not buying more to feel better about the loss– I’m buying more because that is my plan.
After I’ve accumulated as many shares as I had planned, if the stock takes a substantial dip, I take a step back and reevaluate the stock. Is the company’s earnings growth slowing down after a torrid pace, and therefore is the price-earnings multiple it carried before may no longer justified? Did I miss something about the stock? Is the entire sector slowing down, and is this stock just being pushed with the tide? If I find that the answer is one of the first two reasons, I’ll generally just sell the stock, take my loss, and get on with life. If the cause is the third reason, I may average down if I don’t have a better prospect because the company may gain market share from the weaker competitors and race ahead of the sector when it recovers.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.