Why I Average Down

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.

Comments

  1. says

    I think averaging down, on a solid company is an excellent strategy, as is buying on the dips. Sometimes you have to have the fortitude and patience to hold a plummeting stock, since a good company will usually rebound.

    Most investors don’t have the patience to hold a stock for 6 months or a year, or even 2 or 3 years for that matter, to reap the rebound. They throw in the towel early. More often than not they lose money, selling at the bottom, only to see the stock turn around a few months later.

    Andrew Hallam just provided some interesting information on my pick of MCD, where the price tanked in 2003 from about $30 to $13 per share. Investors who sold in a panic lost big time. For those who knew that MCD was rock-solid, they could average down to an average of say $20 per share, over a 16 month period, and they would have quadrupled their investment by now :)

    http://andrewhallam.com/2011/08/investment-club-makes-its-first-trade-in-years/

    Cheers
    The Dividend Ninja

  2. says

    Ninja,

    Excellent example with MCD! I would have loved to be an investor back in ’03 and be long on MCD. Amazing prices there.

    Patience is the keyword here. If you don’t have patience, then averaging down probably isn’t even in your vocabulary.

    Different strokes for different folks. One man’s stop loss is another man’s limit order! I’m long-term and I love nothing more than increasing a position if the price goes down and fundamentals stay the same.

    Take care! :)

  3. says

    Mantra,

    I agree with averaging down! If the fundamentals haven’t changed and the stock goes on sale…who doesn’t love a sale? Most people panic out of the stock accelerating the price drop and then the smart money swoops in and grabs a bargain, stabilizing the price. As the price goes back up, the people who panicked out of the stock try and catch it on it’s way back up. That almost never works and you wind up with a loss.

    My only problem is when the market is irrational and the whole stock market goes on sale, I never have enough cash on hand to average down on all my positions. Oh well…

    Cheers!

    Income Pirate

  4. says

    Pirate,

    I agree with you! Who doesn’t love a sale? I know that I’m always excited when I see quality on sale.

    I hear you on the liquidity conundrum. I try to be fairly fully invested to maximize my returns, as cash earns very little…but you have to strike balance and have dry powder on hand for when Mr. Market gets moody. It’s a tough balance to strike.

    Keep in touch!

  5. Anonymous says

    I have practiced ‘averaging down’ for the past 3 years but only during dramatic declines in the markets.
    I am not worried about the market itself I only consider if my prey declines to below it’s 1-3 year trading band.
    With more capital and lower discount brokerage fees averaging down becomes economically feasible.
    I find try to take a small bit of my prey upon a decline below 52 week lows while lying in wait for it to plummet even lower to take a full bite.
    Assetologist

  6. says

    Anonymous,

    It sounds like you have a great plan going on. I agree with you that the lower brokerage fees that we have now have helped this strategy. It’s no longer prohibitively expensive to average down when transactions cost $4-10. Keep up the great work, and I’m sure your strategy will work great over the long haul.

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