When to Use Averaging Down as an Investment Strategy

As an investment strategy, averaging down involves investing additional amounts in a financial instrument or asset if it declines significantly in price after the original investment is made. While this can bring down the average cost of the instrument or asset, it may not lead to great returns. It might just result in an investor having a larger share of a losing investment, which is there is a radical difference in the opinion among investors and traders about the viability of the averaging down strategy.

Proponents of averaging down view it as a cost-effective approach to wealth accumulation. It is often favored by investors who have a long-term investment horizon and who adopt a contrarian approach to investing. This approach refers to a style of investing that is against, or contrary to, the prevailing investment trend.

Example of Averaging Down

For example, suppose that a long-term investor holds Widget Co. stock in their portfolio and believes that the outlook for Widget Co. is positive. This investor may be inclined to view a sharp decline in the stock as a buying opportunity, and probably holds the viewpoint that other investors are being unduly pessimistic about Widget Co.'s long-term prospects (a contrarian viewpoint).

An investor who adopts an averaging down strategy might justify this decision by viewing a stock that has declined in price as being available at a discount to its intrinsic or fundamental value.

Conversely, investors and traders with shorter-term investment horizons are more likely to view a stock decline as an indicator of the future performance of the stock. These investors are more likely to espouse trading in the direction of the prevailing trend and are more likely to rely on technical indicators, such as price momentum, to justify their investing actions.

Using the example of stocks of Widget Co., a short-term trader who initially bought the stock at $50 may have a stop-loss on this trade at $45. If the stock trades below $45, the trader will sell their position in Widget Co. and crystallize the loss.

Advantages of Averaging Down

The main advantage of averaging down is that an investor can bring down the average cost of a stock holding substantially. Assuming the stock turns around, this ensures a lower breakeven point for the stock position and higher gains in dollar terms (compared to the gains if the position was not averaged down).

In the previous example of Widget Co., the investor can bring down the breakeven point (or average price) of the position to $45 by averaging down through the purchase of an additional 100 shares at $40, on top of the 100 shares at $50:

• 100 shares x $(45-50) = -$500
• 100 shares x $(45-40) = $500 
• $500 + (-$500) = $0

If Widget Co. stock trades at $49 in another six months, the investor now has a potential gain of $800 (despite the fact that the stock is still trading below the initial entry price of $50):

• 100 shares x $(49-50) = -$100
• 100 shares x $(49-40) = $900 
• $900 + (-$100) = $800

If Widget Co. continues to rise and advances to $55, the potential gains would be $2,000. By averaging down, the investor has effectively "doubled up" the Widget Co. position:

• 100 shares x $(55-50) = $500 
• 100 shares x $(55-40) = $1500 
• $500 + $1500 = $2,000

If this investor had not averaged down when the stock declined to $40, the potential gain on the position (when the stock is at $55) would amount to only $500.

Disadvantages of Averaging Down

Averaging down is only effective if the stock eventually rebounds because it has the effect of magnifying gains. However, if the stock continues to decline, losses are also magnified. In instances where a stock continues to decline, an investor may regret their decision to average down rather than either exiting the position.

Therefore, it's important for investors to correctly assess the risk profile of the stock being averaged down. However, this is easier said than done, and it becomes an even more difficult task during stock market declines or bear markets. For example, during the financial crisis in 2008, household names such as Fannie Mae, Freddie Mac, AIG, and Lehman Brothers lost most of their market capitalization in a matter of months. It would have been very difficult for even the most experienced investor to accurately assess the risk of these stocks prior to their decline.

Another potential disadvantage of averaging down is that it may result in a higher weighting of a stock or industry sector in an investment portfolio. For example, consider the case of an investor who had a 25% weighting of U.S. bank stocks in a portfolio at the beginning of 2008. If the investor had averaged down their bank holdings after the precipitous decline in the majority of bank stocks during that year, these stocks may have ended up composing 35% of that investor's total portfolio. This proportion represents a higher degree of exposure to bank stocks than the investor originally desired.

Tips for Executing Averaging Down

Some of the world's most astute investors, including Warren Buffett, have successfully used the averaging down strategy. Averaging down can be a viable strategy for average with these recommendations.

Restrict Averaging Down to Blue-Chip Stocks

Averaging down should be done on a selective basis for specific stocks, rather than as a catch-all strategy for every stock in a portfolio. Averaging down is best restricted to high-quality, blue-chip stocks where the risk of corporate bankruptcy is low. Blue chips that satisfy stringent criteria–a long-term track record, strong competitive position, very low or no debt, stable business, solid cash flows, and sound management–may be suitable candidates for averaging down.

Assess a Company's Fundamentals

Before averaging down a position, the company's fundamentals should be thoroughly assessed. The investor should ascertain whether a significant decline in a stock is only a temporary phenomenon or a symptom of a deeper malaise. At a minimum, these factors need to be assessed: the company's competitive position, long-term earnings outlook, business stability, and capital structure.

Consider the Timing

The strategy may be particularly suited to times when there is an inordinate amount of fear and panic in the markets, because panic liquidation may result in high-quality stocks becoming available at compelling valuations. For example, some of the biggest technology stocks were trading at bargain levels in the summer of 2002, while the U.S. and international bank stocks were on sale in the second half of 2008. The key, of course, is exercising prudent judgment in picking the stocks that are best positioned to survive the shakeout.

The Bottom Line

Averaging down is a viable investment strategy for stocks, mutual funds, and exchange-traded funds. However, investors should exercise care in deciding which positions to average down. The strategy is best restricted to blue-chip stocks that satisfy stringent selection criteria such as a long-term track record, minimal debt, and solid cash flows.