Amid the chaos of changing economic information and company news, committing to a trading strategy helps investors to remain focused. Averaging down is a simple strategy investors use for this purpose. When investors average down, they add shares of an existing position at a lower cost basis. The underlying theory is that purchasing more shares at a lower cost reduces their average price.
Averaging down can be considered a contrarian approach to investing because an investor who uses the tactic buys shares as the price of the stock declines. While most investors are concerned with reducing risk, investors who average down appear to increase the level of uncertainty that they expose to their portfolios.
By purchasing shares as their prices decline, investors raise the possibility of losses. However, the technique can actually reduce the level of risk in a portfolio if used correctly.
Through the rebalancing of shares in a portfolio, investors can use averaging down as a tool to realign the weights of different assets. The end goal of this practice is the acquisition of stocks when they are undervalued. If the stock's price improves, then so too will the profitability of the overall portfolio because the average cost basis of shares will have fallen. Regardless, traders must exercise caution when averaging down to trade. If the price of shares continues to decline, traders face the risk of increasing their loss in the original trade. Accordingly, financial professionals are divided on the viability of averaging down due to the potential for losses.
Financial advisors typically argue that averaging down is a useful strategy when markets are in decline and highly volatile with larger shifts in prices. Such scenarios offer the potential for huge profits in the event that prices reverse, increasing the possibility of profits with proper timing.
However, professional traders at hedge funds often oppose the use of averaging down. These traders are measured, often on a monthly or quarterly basis, on their ability to outperform benchmarks. By averaging down their investments, they reduce the total value of portfolios, which negatively affects their clients’ returns. Accordingly, traders at hedge funds are usually less inclined to use this trading strategy.
The contrasting views of financial advisors and professional traders concerning averaging down raise an important question. Should traders pursue averaging down as an investment strategy? The answer depends on factors such as the investor’s objective and timeframe as well as the security being considered for purchase. Usually, the benefits from averaging down during volatile markets take time to realize. Most wealth managers would recommend that investors who average down take a long-term position in diversified products like ETFs in order to profit from averaging down. Averaging down is riskier when trading single-name stocks because they carry the risk of going to zero.
Besides, most financial professionals that advocate a buy-and-hold strategy would agree that adopting a value-driven viewpoint is important. Investors who buy index funds can better justify the decision to average down because data supports that a diversified index of equities tends to rise in the long term. However, averaging down can be dangerous when investing in declining shares without diversification.
In the example below, the trader lowers the cost basis of the shares to $438. The investor begins with 100 shares of SPY that were bought at $440 totaling $44000. By purchasing an additional 100 shares at $436 (assuming no transaction costs), the investor adds more shares to the portfolio.
The trader has 200 shares purchased at an average price of $438. As a result, the cost basis for the shares is $87,600. The trader would have had to spend $88,000 to purchase the 200 shares at the original price of $440. Consequently, the individual is effectively saving $400 from the cost of building the portfolio.
The aim of averaging down is to lower the breakeven point, the point at which investors can choose to hold or sell stocks without incurring losses, by lowering the average price of shares. By comparing the average value (traded) of selling shares to their cost, traders can determine the breakeven point. In this case, the breakeven point occurs when the cost equals average value. Lowering the cost of stocks means traders can break even faster and leave a losing position easier.
As you can see, the strategy can only be effective if stock prices recover from a downward trajectory. If they continue to fall, investors lose money. Consequently, they are unable to break even on their investment.
The potential for losses when averaging down requires investors to understand the point at which they should sell their stocks. As a result, investors must develop a structured approach when averaging down — one example of this could be setting a price limit beyond which they will abstain from averaging down.
Some of the world's most astute investors in the securities markets have realized the importance of buying equities at prices that are intrinsically low. Averaging down helps investors to achieve this goal. In this way, investors can buy assets that have the potential to increase in price. However, realizing this goal requires investors to think carefully about the actions they should take if they want to benefit from the trading strategy.
First, they should appreciate that averaging down can only be done on selected stocks in a diversified portfolio rather than viewing it as a “one-size-fits-all”. The stocks of companies that satisfy stringent requirements – long-term improvement in financial performance, low debt, stable cash flows, and strong competitiveness in the market – should be considered candidates for investment using this approach.
Second, investors should assess the fundamentals of exchange-traded funds (ETFs) thoroughly before averaging down a position. In this case, they should have quality historical information on the ETF including the risks and historical fluctuations. Backtesting the historical information using averaging down will help to evaluate the effectiveness of averaging down the ETF. This helps investors reduce the risk involved in using this trading strategy.
Lastly, consider the timing of the purchase of additional shares. Averaging down is suited for periods when investors are fearful and anxious about the performance of the market. Apprehensive investors often sell high-quality shares increasing their supply in the market at a time most investors are unwilling to purchase more shares. Economic theory dictates that an increase in supply without a commensurate rise in demand results in lower prices. Accordingly, the key is to choose shares that are positioned to overcome the decline in the performance of securities markets.
Investors can reduce the average cost basis in a portfolio. Assuming the shares that have been purchased through this strategy rise, the practice ensures a lower break even point for the investment when compared to a scenario where the investor did not average down.
The averaging down strategy enables traders' "buy low, sell high" attitude, which is a critical component of profits”
Flexibility is another advantage of averaging down. Investors can modify their predefined parameters at any point, for example, by lowering or increasing the point and frequency at which they buy shares, calibrating the practice to different market conditions.
The ease at which averaging down can be practiced also encourages investors to regularly commit additional sums of money to their investment portfolios, which could yield positive results for any investor with a long-term horizon. Regular investment is an important part of growing an investor’s wealth.
The averaging down strategy enables traders' "buy low, sell high" attitude, which is a critical component of profits. As with most investments, investors aim to buy shares to generate income or benefit from price increases. By paying a lower average price for buying shares and selling them at a higher average price, traders profit from the use of this trading strategy.
Averaging down means investors purchase more units of stock as prices fall. As the unit price of a stock declines, the value of a portfolio also diminishes. This is a major risk if the asset price does not recover, making it a risky strategy for single stocks.
The overall risk exposure of a stock portfolio may also increase. Averaging down will naturally expose investors to markets that are declining, increasing the volatility of their portfolios.
Investors often develop an emotional attachment to a particular stock, increasing the risk of greater losses if they continue to buy shares as the price of a stock falls. The reality is that choosing individual shares is difficult. Most shares take a significant amount of time to recover their original price after a decline. Add the problem of knowing when to purchase and when to sell shares (market timing) and investors expose themselves to considerable risk when they choose this trading strategy.
Averaging down is a simple strategy any investor can apply to the markets. It allows investors to remain focused on their investment goals by committing to a pre-defined, mechanical investment method, that they can practice regardless of what is happening in the markets overall.
Nevertheless, investors should exercise caution when using the trading strategy. Purchasing single stocks and assembling an undiversified portfolio could lead to greater risk of losses. As a result, the execution of the trading strategy requires a thoughtful and disciplined approach.
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