I believe fully in averaging down on my positions. If a position I’ve committed money to loses value, but the fundamentals remain the same, then this presents a long-term investor such as myself an opportunity to lower my overall cost basis on that position.
Per Investopedia, the definition of averaging down is:
“The process of buying additional shares in a company at lower prices than you originally purchased. This brings the average price you’ve paid for all your shares down.”
When the shares of a company you own go down in value suddenly and drastically you can do one of three things.
First, you can sell the shares. This would usually be a good idea of the fundamentals of the company has changed, the long-term outlook of the company has drastically turned negative or the company changes the way it does business and you no longer agree with the direction it is going in. A dividend cut would be a prime example.
Your second option is remaining pat and doing nothing. This might be a good idea if you’re unsure as to why the market value has gone down so quickly. Also, if the guidance provides a murky short-term outlook it might be a good idea to hold your shares and commit more time to closely watching any news from the company. Remaining still might also be a good idea if the position is already beyond your normal level for asset allocation and diversification. For instance, if company Z falls 10% in value drastically, but it is already 12% of your portfolio and you usually limit individual equities to 10%, you probably do not want to commit more money. Raising your risk profile on a falling equity may not be the best idea. This really depends on your risk profile.
Lastly, you can purchase more shares. More often than not, this is what I’ll do. If the overall market drops drastically, such as it recently did, most companies go down with the market. This provides a logical investor an opportunity in an illogical market. Usually, if I commit money to a position I’ve done my homework and feel comfortable having my hard-earned money invested in said company. If the value falls, but the long-term outlook remains stable, then there is no reason I wouldn’t want to commit more money. It goes along the lines of “if I like company Z at $40, I love it at $30″.
I don’t believe the market is efficient. I believe there are undervalued and overvalued securities in any market any time of day. Sometimes a company turns unpopular. Often, a company will narrowly miss unrealistic earnings estimates. Perhaps the trading volume falls due to something new and shiny in the market (LinkedIn anyone?). There are many reasons a security may fall in value unjustly. When it does, I’ll be there to swoop in and buy more.
But, that’s me. What about you?
Thanks for reading.