Averaging Down
Key takeaways
- Averaging down is a strategy that helps to lower your average holding cost of a stock.
- The strategy can be effective only when the fundamentals of the business remain strong.
- Investors should reassess fundamentals, valuation, portfolio concentration, and risk before averaging down.
Suppose you bought a stock at ₹200, and the price falls to ₹150. Would you wait for it to recover or sell it? Or buy more shares at the lower price?
“Averaging down” refers to a strategy where you buy additional shares when the price of a stock declines. The idea is to buy more shares at a lower price, so that the average cost of the overall holding comes down.
Investors, however, should understand that a lower average price doesn’t simply mean lower investment risk or higher profit potential. A stock with weak fundamentals can continue declining after you average the prices. So, it’s crucial to know why the price is declining in the first place.
This guide explains how averaging down works, how you can calculate the new average cost, and factors to consider before making such a decision.
What is Averaging Down?
Averaging down is an approach to investing where you buy additional shares of a company when its market price falls below the price you had paid for the existing holding. As the extra shares are purchased at a lower price, the average cost of all the shares comes down.
For example, let’s assume that an investor buys 100 shares of a company, valued at ₹200 each. The initial investment, therefore, comes to ₹20,000.
The stock price drops to ₹150 later on, and the investor again buys 100 shares, putting in another ₹15,000.
Now, the investor owns 200 shares for ₹35,000 as the total investment. The average cost per share was originally ₹200, but now it becomes ₹175.
The average cost of the holdings has fallen because the investor has put in additional money at a lower price. A lower price, however, doesn’t mean the stock has become less risky.
If the price of the shares falls further to ₹120, the investor will face a loss even after averaging at ₹150. Therefore, do not simply treat averaging down as a strategy to make a losing position profitable. The future prospects of the company and the reason behind the decline in price remain relevant.
How does Averaging Down work?
Averaging down involves only a few steps. Although the process is simple, the decision to make each additional purchase requires careful evaluation.
Make the initial investment
First, purchase the shares of a company at a particular price. For example, you may buy 100 shares at ₹200 each.
The stock price declines
After a few weeks, the market price of the stock falls below your purchase price, say to ₹150. At this point, you have an unrealised loss.
Reassess the investment plan
Now, examine why the price declined. It may have fallen due to volatility of the broader market, temporary weakness in the sector, weak quarterly results, or changing business conditions. At times, the fundamentals of the company may have seriously deteriorated, leading to the decline.
Buy additional shares
If your original investment thesis remains valid and the risks seem acceptable, you can buy additional shares at the lower price.
Recalculate the average cost
Average cost per share = Total amount invested ÷ Total number of shares held
Divide the total amount invested by the total number of shares you hold to determine the new average cost. Suppose the average cost comes to ₹175 after purchasing another 100 shares at ₹150. If the market price eventually rises above ₹175, the position will be profitable for you, and you may consider exiting at any price above this level.
You must try this Stock Average Calculator
Averaging Down vs Averaging Up
With averaging up, you purchase additional shares after the price has increased. Both averaging down and averaging up involve adding to an existing position. But these strategies are implemented under different price conditions.
When can Averaging Down make sense?
A declining stock price doesn’t necessarily mean that the underlying business has become weaker. Markets may fall due to economic conditions, sector-wide selling, temporary uncertainty or changes in investor sentiment.
as an investor, you need to evaluate the cause of the decline, and in some situations, you may consider adding to an existing position. Here are certain conditions when averaging down makes sense.
Temporary market-wide correction
Even when the underlying business remains stable, a stock price may fall when the broader market declines. If this decline is primarily associated with short-term volatility in the market, you may consider adding more shares to capitalise on the lower valuation.
Short-term volatility
Prices of stocks may fluctuate due to news updates, changing expectations of investors, or market sentiment. If the decline is temporary, averaging down makes sense for long-term investors.
Strong fundamentals
Examine the revenue, profitability, cash flows, debt levels, competitive position, and other relevant fundamentals before you add to an existing position. If the business continues to perform as per the original analysis, you may consider buying additional shares.
Long investment horizon
With a longer investment horizon, you gain more time to wait through periods of volatility in the market. However, a long horizon alone doesn’t make every stock suitable for averaging down.
Risks of Averaging Down
Averaging down can reduce the average cost of an existing holding. But it also requires you to expose more capital to the market. Several risks must be considered before you use this strategy while investing.
The stock may continue falling
The biggest risk of averaging down is weak fundamentals. A stock may not recover even after you make the additional purchase. A decline from ₹200 to ₹150 does not mean that ₹150 is the lowest possible price. The stock can even fall under ₹100 if the fundamentals of the company or market conditions deteriorate.
Concentration increases
As you continue to average in dips, the size of your holding increases. Ultimately, this increases the risk profile for your portfolio. The position may become disproportionately large compared to your overall portfolio size, leading to a concentration risk on a single stock.
Overlooking fundamental deterioration
Consistently falling prices often point to deteriorating fundamentals of a company. However, if an investor mistakes a decline in price for a better valuation, they may eventually overlook rising debt or declining earnings. The company may even lose market share or be affected by regulatory changes.
Emotional decisions can influence the process
Investors may find it difficult to accept a loss after buying a stock. At times, this creates a tendency to buy more shares simply to bring down the average purchase price. Averaging down should not be a strategy to recover a previous loss. You need to re-evaluate the fundamentals and make a fresh decision based on the current information.
Common mistakes investors make
One of the key mistakes is to buy more shares without understanding why the stock price declined. Although a lower price may appear attractive, the decline may reflect changes that affect the future prospects of the company.
Another mistake is to assume that a stock is cheap simply because it is trading below the purchase price. The original purchase price doesn’t determine whether the current price holds good value.
It’s possible for investors to overlook financial performance. If the earnings, cash flows, or other crucial business indicators have weakened, adding to the position on each dip may increase risk.
Sometimes, investors with unused capital average down but do not set any limit. With multiple purchases on dips, a small position can turn into a large one. This eventually leads to concentration risk.
The most serious mistake to avoid is confusing a lower average cost with lower risk. The average cost may decline even after additional purchases. But you remain exposed to the future performance and market movements of a company.
How to decide whether to Average Down?
Before you add more money to a falling investment, consider a few practical questions. A calculated approach can help you decide whether averaging down would be a sound decision.
Why did the price fall?
Evaluate the reason for the decline to start with. Volatile markets and a deterioration in the fundamentals of the business may have very different implications.
Has the logic behind your investment changed?
The reason for holding on to the original investment may no longer remain valid. Check whether the earnings outlook of the company, competitive position, and growth prospects remain consistent with your original analysis.
Is the current valuation reasonable?
If a stock trades below its previous purchase price, it doesn’t become undervalued automatically. Consider valuation in the context of the financial performance and future prospects of the company.
How large is the existing position?
In a scenario where you already have a large holding, averaging down can increase the concentration risk. Look at the size of the position in relation to your overall portfolio.
Can you afford to invest more?
The additional investment must be manageable through the available funds. Your essential financial requirements or emergency fund should not be disrupted.
What is the investment horizon?
A longer investment horizon gives you more time to handle volatility. However, it doesn’t eliminate the possibility of permanent capital loss.
How much loss can you accept?
Consider your risk tolerance and decide how much loss you can accept. It’s important to analyse the potential downside before you increase your exposure.
Conclusion
Averaging down can be a useful strategy to reduce the purchase cost of a stock by adding more shares at dips. But it pays to take guard against the investment risks associated with this strategy. Simply lowering the average cost without analysing the business fundamentals can expose you to market risk and concentration. A falling price doesn’t always offer better valuation, and neither does it guarantee a recovery.
Before you average down, take time to study the company’s fundamentals and evaluate current market conditions. If your original logic behind the investment still makes sense, you may buy additional shares to lower the average cost.
FAQs
What do investors do when they average down?
When investors average down, they buy more shares of a company that they are already holding at a lower price than the current purchase price. As the new shares are purchased at a lower price, the average cost of holding decreases.
Is averaging down a good investment strategy?
Averaging down can be a good investment strategy only in situations where the original logic behind the investment remains valid despite a temporary decline in price. Investors must assess the reason for the decline, fundamentals, valuation, portfolio concentration and their ability to take additional risk before deciding.
How does averaging down reduce the average cost?
The average cost of your holding decreases when you buy additional shares at a price lower than the original purchase cost. You can calculate the new average by dividing the total amount invested by the total number of shares held.
Can I average down in mutual funds?
Averaging down in mutual funds is a good strategy. When the market declines, you can buy more units at a lower NAV. This means you’re buying a higher number of units with the same amount of money.
Is averaging down the same as SIP investing?
No. Averaging down requires you to deliberately buy more shares when the price of a stock declines. An SIP, on the other hand, involves investing a predetermined amount at regular intervals, regardless of market conditions. SIPs can help you buy more units when NAVs are low as part of a long-term investment. But the purchase is automated and doesn’t involve your discretion in considering market downturns.
