We analyze what Average Down means and the risks involved in the process. We also discuss which assets are eligible for this strategy and which not.
- Risks of Averaging Down
- Assets We Should Not Average Down
- Assets We Can Average Down
Averaging down is an investing strategy that consists in buying more of an asset as its price falls. Because we are able to buy that asset cheaper, we can bring down the average cost we paid for it.
Let us illustrate how that works with an example:
- We buy 100 shares of Google at $150
- When the price drops to $135, we buy another 100 shares, bringing the average cost down to $142.50
- Later, the stock price falls further until $100, when we buy 100 more 100 shares. We bring down the average cost to $128.33
The logic of averaging down is that, if a stock was attractive at $150, it is much more attractive at $135 or even $100. Therefore, it makes sense to increase our position as the potential for future profits gets larger.
Another positive aspect if we average down with good timing is that, once the stock starts to rebound, our position will get into positive P&L sooner than if we had not averaged down at all.
Although people tend to average down with stocks, it is a strategy that can be used with other types of assets. In fact, in the next few sections, we will talk about those assets with which it is relatively safe to average down and those we should avoid. Coincidentally, averaging down with individual stocks is not the best idea in the world.
Risks of Averaging Down
Averaging down can be one of the most dangerous things we do when investing. Especially if we are not aware of the risks involved.
The rationale for averaging down is that we are so confident that the price of an asset will rise in the future that we are willing to put more money in it as we start to experience losses.
That conviction must be based on sound analysis. It cannot be simply because you looked at a chart and noticed that a stock had dropped a lot.
Or, worse yet, because your emotions take over, and you are unable to see a losing position in your portfolio. Unfortunately, this happens more often than you think.
If we are simply averaging down because we want our position to go break even as soon as possible so that we can get out without a loss, chances are that stock will never rebound enough for that to happen.
And even if it did, that may take a very long time and the opportunity cost by then may be enormous.
In those situations, it is probably better to liquidate that position and move on. Losses appear when an investment drops, not when we sell. We are not avoiding any losses by keeping a position.
Assets We Should Not Average Down
The biggest risk when it comes to averaging down is that the price never recovers to a level that is high enough. The worst-case scenario would be a stock going to 0 which is completely possible.
It is often said that the stock market always goes up in the long run, but that is a fallacy. Let us analyze why:
First, the stock market that has always gone up in the long term has been that of the United States, the emerging economic superpower of the 20th century. Such statement does not apply to many other countries.
But even in the United States, there have been periods in history when the stock market lost more than 80% of its value. It has then taken more than three decades to recover the previous high. Therefore, positive returns are never guaranteed.
Secondly, although the nominal value of our initial investment may have been recovered, we need to consider inflation and opportunity costs. A flat investment for 10 years is very detrimental in times of elevated inflation or other booming markets.
For example, those who invested in the Japanese stock market in the late 1980s may be close to breakeven three decades later. But that ignores the fact that they missed an incredible rally in pretty much any other stock market in the world.
Thirdly, although many assets have the potential to eventually recover, not all do. Many assets are not eternal, especially stocks. Stocks represent ownership in companies, and companies eventually disappear.
The following video tracks the largest companies in the world since 1979. You will notice that very few of them manage to stay at the top. In fact, most of them end up becoming a fraction of what they were. When it comes to individual stocks, there is always a significant probability that the highs may never be seen again.
Therefore, it is not advisable to average down with individual stocks. Whether they end up going down by 70%, 90% or even straight to 0 does not matter. There are usually good fundamental reasons for a declining stock price. Why would we want to invest more in a business that is declining when others are growing?
Assets We Can Average Down
Let us now move on to those assets that we can average down. Those tend to have less risk in the long term. But bear in mind they still have risk. Even the almighty S&P 500 have gone through various periods throughout history where returns after more than a decade were negative.
Nonetheless, there is generally less risk in averaging down assets that are more of a macroeconomic nature. This is because they usually have a specific role in the global economy and are very unlikely to ever go away.
Finally, we must touch on the importance of diversification in our portfolio if we are considering averaging down certain assets. Generally, the more diversified our portfolio is, the less risky it is to average down.
If our portfolio has stocks from all over the world, gold, commodities, cash, bonds, and real estate, we can afford to take certain risks. It is all about the size of our positions and the risk of our wealth going down dramatically.
Conversely, if our portfolio is made up of only 5 stocks, averaging down is a very dangerous thing to do. While the potential returns may be higher, the risk we are taking is extremely high.
What is always crucial is to make sure we are in control of our emotions and analyze investments from an objective perspective.
Most assets can be bought and sold at almost any time. If you have invested $10,000 in a company, and that investment is down to $8,000, ask yourself the following: If I had the $8,000 in cash right now, as opposed to that stock, would I buy those shares? If the answer is no, it is generally best to sell. Otherwise, you are letting your emotions cloud your investment judgement.
Averaging down can be very dangerous. That does not mean you should never do it. There are situations in which averaging down makes sense. You simply need to be aware of the following variables:
- What role does this asset have in my portfolio?
- Would I buy it right now if I had the cash instead of the asset?
- What is the probability that its price will never recover, or take decades to do so?
Once you have answered these questions in an honest manner, you will be in a better position to take beneficial long-term decisions.
If you liked this post, I encourage you to subscribe to my newsletter:
And if you want to read more about learning how to invest, check out this section:
Learn How to Invest