An average down is an investment strategy that refers to buying more shares of a stock already owned at a lower price than what was previously paid. The overall effect is to bring the average down on the price paid for the shares. Most experts agree that the average down strategy is only beneficial in certain cases.
The average down calculation is simple arithmetic. It involves dividing the total amount of money invested in a certain stock by the number of shares held. For example, say an investor buys 50 shares of company A for $10 US Dollars (USD) and then decides to average down when the stock drops to $8 USD by buying 50 more shares. To calculate the new average cost of his or her shares, the investor would take the total spent on the shares — $900 USD — and divide it by the total number of shares, in this case 100, to come up with the average share price of $9 USD.
In this case, the investor effectively reduces the amount he or she has “lost” on the stock by half. Rather than being down by $2 USD per share, as the investor was when the stock dropped to $8 USD, he or she is now only down $1 USD per share. This type of average down strategy is often used as a response to short-term market changes.
Dollar-cost averaging is a specialized form of averaging down. Rather than being the reactionary strategy, however, it is usually a consistent, planned strategy designed to take advantage of stock market changes over the long term. One of the most common examples of dollar-cost averaging is a typical retirement fund, such as a 401(k) plan, that invests in mutual funds. In general, participants in these types of plans contribute a set amount every month that goes toward buying mutual fund shares at the current market price. Some months an investor will be able to buy more shares and other less, with the overall cost per share determined by the same average down calculation described above.
In general, the goal of averaging down is to come out better off than one might have otherwise. Whether looking to maximize profits or just minimize losses, to be successful, the share price typically must rise beyond the average cost per share. For example, if the investor of company A mentioned above is later able to sell his or her shares for $10 USD, he or she has made a $1 USD per share profit based on the averaged down cost per share of $9 USD. If this investor had stuck with just the shares bought at $10 USD, he or she would only have broken even.
Experts generally agree the average down strategy should only be used if an investor is confident that share prices will rise. They usually caution that buying more shares of a stock that is losing value can be a risky proposition. If the share price continues to fall, the investor will typically just end up with more shares to sell at a loss.