The term averaging down stocks refers to an investment strategy of purchasing additional shares of a stock by an existing shareholder after the price has dropped. Hence, the average stock price is lower for the second purchase than when the investor initially bought shares.
The strategy has risks, though, because whether the stock price drops more or recovers is unknown. An investor is likely exposed to further losses if a company performs poorly, and the decline is not temporary. Consequently, the strategy is potentially risky. However, experienced value investors, like Warren Buffett, often employ the technique. Short-term traders also use the method.
Notably, the term averaging down is not exactly the same as dollar cost averaging (DCA). In this strategy, a person invests the same amount of money in a fixed time interval, regardless of whether the stock price increases or decreases. Besides stocks, the DCA strategy is often followed for owning exchange-traded funds (ETFs) or mutual funds in retirement plans.
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Example of Averaging Down
For example, an investor buys 50 shares of Company XYZ at $100 per share. Then, the stock price drops because of poor earnings results or a bear market to $80 per share. Afterward, the investor buys another 50 shares. Hence, the average price or cost basis is now $90 per share.
Why Average Down?
When investors average down a stock, they acquire more of a company they intend to accumulate at a discount. Often, the stock is undervalued, and they buy more shares to increase their potential gains. The strategy is usually price driven and not based on fundamentals, like the price-to-earnings ratio or other valuation metrics.
Using the above example, the stock price has dropped 20%, but it must rise 25% to return to breakeven. However, by averaging down, the stock price must gain only 12.5% for an investor to start notching a profit. The breakeven price is the same as the average price of $90 per share. If the stock price rises to $100 per share, the person realizes a gain, unlike before averaging down.
The average price and the breakeven price depend on the number of shares and cost.
The breakeven price formula is:
= [(number of shares bought) x (purchase stock price) + (number of shares bought) x (second purchase stock price)] / total number of shares
Advantages and Disadvantages
The strategy’s advantage is that one may accumulate a stock temporarily mispriced, essentially a value investing strategy or buying the dip. The benefit is owning more shares at a lower price. The total return is greater when the share price recovers to the original purchase price. Alternatively, a trader can average down a stock to exit a position at a lower price.
The disadvantage of averaging down is that an investor is buying shares of a company that is declining in value. In addition, if the decline is longer-term, the investor is faced with unrealized losses. For instance, investors following the strategy during the dot-com crash may have waited years to breakeven. Moreover, some companies decline in value because of disruption to their business or another issue. In this case, an investor will experience significant losses.
A second con is buying shares of a stock may shift a portfolio’s asset allocation making it riskier.
Lastly, another disadvantage is capital may be better used buying another stock with better prospects.
Final Thoughts on Averaging Down Stocks
Averaging down stocks is when investors buy additional stock they already own after the price has fallen. The concept is to acquire stocks you own at a discount lowering the cost basis and breakeven point. Value investors and traders use the strategy. That said, it is risky for inexperienced investors because a stock price can decline further. Second, no one knows when the share price will recover.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.