When there are signs of trouble or just a hint of uncertainty, an investment’s price may start going down. Investors may pull their money out to avoid losses or seek better opportunities elsewhere.
However, not everyone is spooked by a downturn. Some people view it as an opportunity to buy more of an investment they already own.
This approach is called averaging down. Learn how it works and the things to consider before following this method.
How averaging down works
Averaging down is an investing strategy where you’ll buy more shares or units of an investment when its price drops. It’s typically used in stock investing, but it can also be practiced with other products like pooled funds.
The goal is to reduce the average cost of your investment in that product and improve your returns over time. This method may work best if you’re investing for the long term and can wait out any fluctuations in price.
Example of averaging down
Let’s say you bought 100 shares of a company’s stock at P50 each. If the price drops to P40, you will only break even and recover losses if the price returns to P50.
However, if you averaged down and bought another 100 shares at P40, your new average cost is P45. This means you’ll already break even if the price goes up to P45.
You’ll start making a profit if the price continues to climb past the average cost of P45, and any price movement below it is a loss.
Keep in mind that recovery isn’t guaranteed. You may end up losing more money if the price drops further after you’ve averaged down.
Moreover, this example doesn’t include fees and taxes you’ll need to pay when buying and selling investments. Such transaction costs can affect your actual returns.
Potential advantages and disadvantages
Is it wise for you to average down during a price drop? That depends on your investing preferences, goals, and attitude toward risk. Here are some pros and cons to consider:
Advantages
If you average down and the price goes back up, you may offset investing losses sooner and improve your returns in the long run if the upward trend continues.
This approach can also have psychological benefits. It may help you manage emotions and gain a sense of control as you go through the ups and downs of investing.
Instead of worrying or panic selling when the price drops, you’ll think long-term and identify whether there’s an opportunity to take advantage of a good deal.
Disadvantages
Averaging down won’t make you money until the price starts rising above your average cost. It can be impossible to predict when this will happen.
If your timing is off, your losses may worsen, or you may need to wait for a long time for your strategy to work. It can even take years for a losing investment to bounce back. Some may never recover at all.
Looking at a company or investment’s fundamentals is one way you might be able to tell the difference between a temporary drop and a warning sign of bigger problems.
Keep in mind that your paper profits or losses only become real when you sell your shares of an investment. Your actual returns may still change if you’ll hold on to that asset for a long time.
It’s always important to do your due diligence and consider your situation and needs before following any investing strategy.
