Investing in more shares of a company with a declining stock price can be a tough decision. This dive can either put you in an advantageous position by enabling you to purchase additional stock at cheaper rates or run the risk of worsening a position that is already bleeding money. This trading strategy is known as averaging down. But before you use it, there are certain aspects you need to focus on to make sound investment calls.
What is averaging down?
Purchasing additional shares at lower prices than what you paid before is called averaging down. It is also referred to as the reduction of the average price at which you bought a company’s stock.
Formula to calculate average down stock:
[(Number of Shares x Initial Purchase Price) + (Number of Shares x Second Purchase Price)]∕Total Number of Shares
Let us understand this concept with an example. Assume you have purchased 100 shares from a company called XYZ, which cost you Rs. 100 apiece, i.e., Rs. 10,000 in total. If the stock price dips to Rs. 50, and you buy an additional 100 shares, you will spend an extra Rs. 5,000. Now, your average purchase price is Rs. 75 (10,000 + 5,000/200). Also called ‘buying the dip”, this exhibits that you are decreasing the original price of owned stock by Rs. 25.
Although your average purchase price has lowered, you will incur a loss on your original stock, i.e., a decline of Rs. 50 on 100 shares, which comes down to a total loss of Rs. 5,000. Buying more stock can’t remedy this loss. Simply put, averaging down should not be seen as a go-to measure for minimising your damages.
Additional read: Large-cap stocks
When to average down on stocks?
There are no standard guidelines for applying this trading strategy. While some may consider it as a technique for wealth accumulation, others may view it as a blueprint for chaos. To use it correctly, you must give serious thought to why a company’s share prices have dipped. If you believe that the stock has plunged because the market has overreacted to a situation and will cool off, then getting more shares makes sense. Similarly, if there have been no fundamental alterations in an organisation, then a reduced stock price can prove to be a lucrative opportunity for acquiring extra shares at an economical cost.
The issue with most investors is their inability to differentiate between a temporary decline and an omen predicting that the prices are about to drop much lower. There might be an undiscovered intrinsic value in a stock, but investing in more shares just for the sake of lowering the average price of ownership is not a valid justification for exposing your portfolio to an increased risk.
Commonly, averaging down is adopted by investors who have a long-term investment vision with a value-driven outlook. They employ meticulously constructed models that make a case for adding exposure to an undervalued stock in conjunction with risk-management manoeuvers.
Additional read: Mid-cap stocks
What are the benefits of averaging down?
- The act of averaging down can expedite the process of achieving breakeven or profitability in a trade, presuming that the share prices increase after taking the position to invest more.
- Even when you average down stock, there is a way to exit a trade at reduced breakeven costs—provided the stock prices rebound. Lowering the average price and then selling to breakeven is a popular tactic used by many investors.
- If the share price bounces back significantly after averaging down, you can gain higher yields. So you not only receive returns on your original investment but also earn money from the position taken to purchase stocks at a cheaper price.
What are the limitations of averaging down?
- The success of averaging down entirely depends on whether the stock price surges again. There could be scenarios where the stock price stays down for a prolonged period. In some instances, it may never go back to its old price, resulting in substantial losses.
- You cannot really anticipate when the share price will recover from a decline. It could drop further or move sideways for weeks, months, or even years while having your funds committed.
- Investing more money into something that’s declining could mean you are passing up on alternative opportunities demonstrating promise to grow your wealth.
Additional read: Small-cap stocks
How to use averaging down effectively?
Here are some tips for using the averaging down strategy successfully.
- Exit strategy: It might be beneficial to invest in the dipping stock, but you should have an exit strategy on standby. Setting a limit would be prudent in case the price continues to fall.
- Exercise due diligence: To gauge if a stock drop is lucrative or not, you need to analyse the company’s financials to deduce the true reason for the decline.
- Trends: Market trends can play an integral role in determining the performance of a stock. So research how certain factors, including news, demand and supply, or competition, are influencing the price drop of the stock and its future trajectory.
Closing thoughts
The strategy of averaging down is a double-edged sword as it could spawn great profits or major losses. You cannot explore its possible benefits without exposing your portfolio to a considerable amount of risk. To decide whether or not to go down this path, you must carry out solid research assessing the company’s fundamentals, market conditions, and long-term repercussions while realistically acknowledging your own risk appetite. If you decide to average down stock, have an exit strategy like stop-loss orders in place to limit any potential losses.
