Averaging down stocks is one of the most common investing approaches used by long-term investors. It allows them to lower their average price per share, and take advantage of market volatility. But when should you do it? How do average down stocks like professional investors?
In this guide, we will go over the advantages and disadvantages of averaging down stocks, and when you should do it.
What is averaging down stocks?
Averaging down stocks is a common investment approach where investors buy more of the same stock when the price goes down. This is a simple way of taking advantage of lower stock prices, and it allows investors to lower their cost base.
One of the most common investment strategies based on averaging down is dollar-cost averaging, which involves purchasing a fixed amount of dollars of the same stock on a daily, weekly, or monthly basis.
When should you average down?
Knowing when to average down, and how to do it exactly is difficult. The stock market is extremely volatile, and you need to be able to add to your positions while leaving some room to average down in case the stock price drops even more.
Before you decide to average down on a stock you need to ask yourself a few questions:
- How much has the stock dropped?
- What is driving the stock lower?
- How long do I want to hold this stock in my portfolio?
- What is the current valuation?
- What will my maximum exposure to the stock be?
- How much more can I add?
- How will this fit my portfolio?
How much has the stock dropped?
Knowing when to average down starts by preparing an investment plan for each stock. Instead of investing a lump sum of money into a stock, invest less at first and wait to take advantage of lower prices. If the stock did not drop significantly, you want to avoid buying and adding a lot of shares because it can continue to drop.
Therefore you need to set the maximum amount you want to invest in stock beforehand and add as the stock keeps dropping. This is one of the simplest ways to catch a falling knife.
What is driving the stock lower?
Understanding what are the reasons that are driving the stock price down is crucial to determining how much you want to invest at first, and how much you should average down. If there is any negative news surrounding the company, you need to approach it carefully.
If the negative sentiment persists, the stock price could continue to decline, and you want to take advantage of the lower prices to average down. There are hundreds of different reasons that could explain why a stock is down. From macroeconomic indicators to specific news about the company.
How long do I want to hold this stock in my portfolio?
You also need to know your investment horizon for this particular stock. If your goal is to invest for the long-term, you can even approach this stock with a dollar-cost averaging strategy, in which you keep adding to it frequently.
However, if you want to take hold of the stock for a shorter time period, you need to be more careful when to average down, since your returns will be a lot more dependent on your average price.
Averaging down works better if you want to hold a stock for the long-term, and you are sure this is a high-quality business, that will remain competitive over time.
What is the current valuation?
To understand how much a stock can fall you also need to consider the stock’s valuation. If the stock is overvalued, it can still have a lot of room to fall. Adding excessively when it starts dipping could mean that you run out of cash to continue to average down as it falls.
On the other hand, if the stock is undervalued you might want to add to it more aggressively since there is a price at which it will attract a lot of attention from deep value investors.
What will my maximum exposure to the stock be?
Before you even buy the stock you need to always consider what your maximum exposure will be. For example, if you are willing to commit 10% of your portfolio to this single stock, perhaps you want to start by investing 3% to 5% of your portfolio.
You will enough margin to average down if the price continues to decline.
How much more can I add?
One of the most common mistakes investors make when averaging down is that they are too aggressive. This can lead to having a higher average share price, and you deploy all the money living you with no additional funds to average down. You need to be able to organize your buying in a way that you can always add more if the price continues to decline.
How will this fit my portfolio?
Finally, you always have to consider how a stock fits in your portfolio. This is why it is important to always set a certain limit beforehand. You want to avoid having large exposure to a single stock just because the price kept going down, and you continued to average down.
Remember that on some occasions the dip keeps dipping, and you need to know what to do.
How to average down
Averaging down starts way before you even buy the first shares. Here is what you need to know about how to average down stocks:
- Set your limit
You want to set a dollar limit or a percentage of your portfolio that you are willing to invest in this particular stock. Ideally, you want to start with less than half of that amount, so you can have more money to get lower prices.
- Understand what is driving the price
If there is a lot of bad news, and the market sentiment towards the stock is very negative, you want to start very small. Otherwise, you will invest a lot of money in a stock that can still drop considerably.
- Monitor the stock price
You should also monitor the stock price at least every day, as you are adding to your existing position. As you see the stock price continuing to drop you want to add slowly, and frequently.
- Avoid averaging down on small drops
If a stock has dropped 5% from when you bought it, you don’t want to double down on your position. You might want to wait until it drops 10% from your average price to add.
- Consider your broker fees
Most brokers have very low fees, but some overcharge. You need to choose a broker that has some of the lowest fees, otherwise, the cost of processing several orders may eat up your possible returns. Consider having multiple broker accounts, especially those with the lowest fees.
Why it is important to start small
If you want to build a large position on a stock that keeps going down, you need to always start small. Especially if this is a volatile stock, or the market has been more volatile. Stocks can be extremely volatile, and to average down and get a lower average price per share, you can’t invest a large lump sum upfront.
This is the best advantage of taking an average down approach vs a lump sum, is that you will be able to get a lower cost per share.
If you invest a lot of money upfront, and every time you average down, you will be left with no money to continue to average down. This is why you should ways start small, monitor the stock price, and keep adding to it.
When should you sell a stock instead of averaging down?
Averaging down stocks does not always make sense. In fact, in some cases where the stock is dropping because fundamental changes in the company are going to affect its financial outlook, it is far better to sell.
When to avoid averaging down?
If something in the company changed, that was not contemplated in your initial stock research, you want to avoid averaging down, and it is better to sell the stock.
You want to average down on winners. Companies with a competitive advantage will be able to grow over time. This is one of the reasons averaging down is one of the approaches used by long-term investors, while short-term traders cut their losses and let their winners ride.
Do you lose money when averaging down?
While you do not lose money when averaging down, there is no guarantee that you will make money. Averaging down allows investors to take advantage of lower stock prices so that their average price paid per share is lower.
Although you do not lose money if you average down, it is impossible to say if you will eventually make or lose money on the stock.
Conclusion
While averaging down is a great strategy to take advantage of lower prices, and boost your portfolio returns, you need to know when and how to average down stocks. Avoid averaging down on stocks with a deteriorating financial outlook, or that you do not want to hold for the long term.
Choose stocks that will perform well over long periods of time, and take advantage of the lower prices to increase your potential returns.
