Averaging down: A Risky Move or a Smart Strategy?

Averaging down is an investment strategy in which an investor purchases additional shares or other assets at a lower price than their initial purchase price. This strategy is employed when the price of the asset has declined after the investor’s initial purchase. Through buying more of the asset at a lower cost, the average cost per unit or share decreases. Averaging down can be applied to various types of investments, including stocks, bonds, commodities, and cryptocurrencies. 

This article provides an example of what averaging down may look like and explores some of the considerations that must be taken into account prior to implementing such a strategy.

Averaging Down – An Example

To illustrate the principle of averaging down, consider the following example. An investor believes in the long-term potential of an AI company’s stock, ABC Tech Pty Ltd, and initially purchases 100 shares at $50 per share, resulting in a total investment of $5,000. However, over the next few months, the stock price declines due to market volatility and concerns about the company’s financial performance.

Initial Purchase:

• Bought 100 shares of ABC Tech Pty Ltd. at $50 per share.
• Total investment: $5,000.
• Breakeven cost: $50 per share

Averaging Down actioned

After a few months, the stock’s price has fallen to $40 per share. The investor believes that the price drop is temporary. Rather than selling the shares at a loss of $1,000, the investor decides to employ an averaging-down strategy.

The investor purchases an additional 100 shares of ABC Tech Pty Ltd at the current price of $40 per share. Here’s how the investment looks after the additional purchase:

• Initial 100 shares at $50 per share: $5,000.
• Additional 100 shares at $40 per share: $4,000.
• Total investment: $9,000
• Breakeven cost: $45 per share

The Opportunity in Averaging Down

With the average cost per share now reduced from $50 to $45, a profit will be realized if the stock’s price eventually rebounds and exceeds $45 per share. If the stock price increases to $55 per share, here is the updated financial picture:

• Initial 100 shares at $50 per share: Original value $5,000, now worth $5,500 — $500 profit.
• Additional 100 shares at $40 per share: Original value $4,000, now worth $5,500 — $1,500 profit.
• Current total value of holdings: $11,000 from an initial investment of $9,000.
• Total profit: $2,000

Risks of Averaging Down

However, if the stock price declines further to $35, the situation would be as follows:

• Initial 100 shares at $50 per share: Original value $5,000, now worth $3,500 — $1,500 loss.
• Additional 100 shares at $40 per share: Original value $4,000, now worth $3,500 — $500 loss.
• Current total value of holdings: $7,000 from a total investment of $9,000.
• Total loss: $2,000

So rather than an opportunity realised there is a compounding of the losses. 

This can be exaggerated further should additional averaging down purchases be made at the new lower price, which some who use this strategy would subsequently action.

What this example aims to illustrate is that despite any potential advantage, merely buying more of an asset because its price has declined doesn’t guarantee that the asset’s value will eventually recover. Without proper research and analysis, investors might be investing in an asset with poor long-term prospects. So, the key message is that this strategy should be based on additional considerations that must form part of the decision making.

Key Considerations for Averaging Down

As we have outlined, averaging down can be a tactical move when executed with careful consideration of the asset’s fundamentals and market trends. It can be particularly effective for investors with a long-term perspective who believe in the asset’s long-term potential. However, the following represent some of the considerations that must be at the forefront of any such decision.

1. Potential for Larger Losses:
   As already referenced but is worth re-iterating, averaging down carries the risk that the asset’s price might continue to decline after additional purchases. This can result in larger losses if the price does not recover as anticipated. The reason for any decline must be fully investigated. Of course, it could be a simple short-term market fluctuation that may be taken advantage of, but it is vital to explore whether there is a more permanent decline in company performance meaning recovery is less likely.
2. Sunk Cost Fallacy:
   Averaging down can lead to a cognitive bias termed sunk cost fallacy (or sunk cost bias), where investors continue investing in a losing position because they’ve already committed capital. This can prevent them from objectively assessing the asset’s true potential and an emotion-based refusal to accept that the loss in value may not recover.
3. Loss of Diversification:
   Overcommitting to an averaging down approach in a single asset can lead to an imbalanced portfolio, reducing diversification and so arguably increasing overall risk.
4. Opportunity Cost:
   Funds used for averaging down could potentially be invested in other assets with better potential for growth. Investors need to assess whether averaging down is the best use of their capital and so by committing more into a single asset may be losing opportunities in another.
5. Time Horizon:
   Averaging down often requires a longer time horizon to potentially realise any potential gains. If an investor needs liquidity in the short term, this strategy might not align with their investment profile or goals.
6. Psychological Stress:
   Sustained declines in an asset’s price can lead to emotional stress for investors who are hoping for a recovery. Emotional decision-making can lead to poor choices.
7. Using averaging down as a substitute for a clearly defined exit strategy:
   Any investment should be underpinned with a soldi and unambiguous risk management foundation. Averaging down is often employed without due consideration of this reality and often employed by those without clearly defined exit points for longer term positions.

Summary 

Averaging down can be useful if applied thoughtfully and with a clear risk management plan. However, it comes with its own set of risks, and investors must carefully consider their risk tolerance, investment goals, and market conditions before deciding to implement this strategy. As always, it’s crucial to maintain a well thought out portfolio, conduct thorough research, and avoid emotional decision-making.