What is averaging down?
Averaging down means buying more of something when the price goes down. This makes the average price you paid for all of it lower.
People do this with stocks and stuff like that. They think if they liked it at a higher price, they should like it even more at a lower price. So they buy more.
An example of averaging down
Let’s say you buy one share of Acme stock for $100. Then the price drops to $75. You still think Acme is a good company, so you buy another share at $75. Now you have two shares and you paid a total of $175.
The average price you paid is $87.50 per share ($175 / 2 shares = $87.50 per share). The first share cost you $100 but the second only cost you $75. Buying at the lower price brought your average cost down.
Why do people average down?
People average down because they want to make money. They think prices will go back up later. If the price does go up, they will make more money than if they only bought at the first, higher price.
Averaging down because you believe in the investment
Most of the time, people average down because they have faith. They believe in the company or thing they invested in.
Maybe you researched Acme and you think they have good management and products. When the stock price fell, you didn’t think anything bad happened to the company. You think the price will bounce back. So you see it as a chance to buy more at a good price.
Averaging down to break even faster
Sometimes people average down just so they can break even faster. They might not even care much about the investment long-term.
Let’s say you paid $100 for that first Acme share. When the price fell to $75, you were down $25. The stock has to go up 33% for you to break even.
But if you buy another share at $75, your average cost is $87.50. Now the stock only needs to go up 14% for you to break even. If it gets back to $100 you’ll be making money again.
Risks of averaging down
Averaging down can be risky. Just because something is cheaper doesn’t mean it’s a good deal. There are a couple big dangers to watch out for.
The price might keep falling
The main risk is that the price keeps going down after you buy more. Then you’ve put more money into a losing investment.
Look at Acme again. You bought at $100 and then at $75. What if bad news comes out and it falls to $50? Your average cost of $87.50 is still way above the current price. You’ve lost even more money than if you didn’t average down.
You might wait forever to recover
The other risk is that the price takes a long time to come back up, if it ever does. You might keep averaging down and down, but the price doesn’t recover. Your money is trapped in this dog of an investment.
Maybe Acme falls to $50 and just stays there. The company isn’t going bankrupt but it’s not growing either. You may never get back to breakeven, let alone make any money.
Deciding whether to average down
Before you average down, you have to do your homework. Buying more just because the price is lower can get you into trouble. You have to be smart about it.
Make sure your reason for investing is still valid
The key is to know why you invested in the first place. What made you think this was a good use of your money?
Did you hear a rumor that Acme was coming out with a new product? But now they announced that it flopped. The reason you bought the stock is gone now. The price might not recover.
But maybe you invested because Acme has a strong brand name and good cash flow. Those are still true at a lower stock price. So you might still believe in the company long-term. It could make sense to buy more.
Have a plan and stick to it
It also helps to have rules around averaging down. Decide ahead of time how much more you’re willing to buy and at what price. Then stick to that no matter what.
Let’s say you want to put a total of $1000 into Acme. You put in $500 at first for 5 shares at $100. The stock then falls to $80. You could use your other $500 to buy 6 more shares. Then you’re done. Even if it keeps falling, you stop buying.
Having a plan removes emotions from your decision making. You’re less likely to keep throwing good money after bad.
