What averaging down means and how it relates to the small investor
Over the years, we have had many subscribers talk about their success averaging down. While others have asked us if they should. The topic is a very relevant and important one to cover. So, let's start with a definition of this investment technique.
What is averaging down?
Averaging down occurs when an investor holds x number of shares of a company at a certain price. Then, that stock's price goes down, so the investor purchases more shares. As a result, the average price paid per share has been decreased. That may seem a little abstract; so, let's look at an example.
Investor A purchases 100 shares of XYZ at $1.00/share for a total investment of $100. Shortly after, the stock falls to $0.80/share. Investor A then purchases an additional 100 shares for $80. Now, his total investment is $180, and he owns 200 shares. So, his initial cost/share was $1.00, but by purchasing more shares as the stock slid, he "averaged down" his cost/share to $0.90.
How does this come in play?
Investor A uses the Bowser Game Plan. After his initial investment, his XYZ holdings would have doubled at $2.00/share. However, because he averaged down, his holdings will now double at $1.80/share--10% less. He also has a larger stake in the company; which was a larger investment up front, but a greater payout in the end.
That sounds great! Why shouldn't investors always average down?
There is no sense averaging down if a stock has little or no chance of appreciating. If you invested in XYZ at $1.00/share and then the company reported quarter after quarter of greater and greater losses, the price is falling for a reason. However, if after you invested in XYZ, the price pulled back a little as the result of a larger market trend, a momentary decrease in investor interest (less trading volume) or just a bad day, then you might consider averaging down.
Consider is the key word. A few things come into play:
- Have you done your research? Is the company's future still just as bright? What category is it in The Bowser Report? If you bought it while in Category 1, but it's now in Category 2 or 3, maybe its prospects aren't quite so high. Why aren't they as high?
- If you put more into this company, would it throw off your portfolio's balance? We talked about diversification earlier this week. An important aspect of diversification is not becoming over-invested in one company. That way a certain balance is maintained.
- Do you have the funds to average down? While averaging down does lessen the average price/share of a particular company, it does mean more cash is flowing into the investment. Do you have enough Proceeds from Sales or cash on the side to afford averaging down?
If all three of these conditions are met, averaging down could be the right decision. After all, if you believe in a company and are within the guidelines of the Game Plan, why not buy a few more shares at what could turn out to be a bargain price?
In short, our answer is: averaging down is a great way to increase the leverage of certain stocks, but certain criteria needs to be met first; criteria that means the difference between turning a larger profit or suffering a bigger loss.