Averaging Down Vs. Averaging Up In Investing/Trading

By: Rupesh Oli

What is Averaging?

Averaging – Dollar Cost Averaging – is the investment strategy wherein an investor invests the capital on a regular period of intervals rather than the lump sum investing at once. Regardless of the current trading price of the particular stock, an investor spreads out his/her investment at regular intervals, be it on a weekly or a monthly basis. Averaging reduces the impact of volatility of the stock market facing the investor. You, as an investor, abolish the mental pressure and hassle to better time the market in order to make the purchase of the stocks at the best price possible, as averaging makes it possible for you to invest at regular intervals despite the price fluctuation of ups and downs in the market.

When you average your investments, you are able to buy more stocks when the market price is low. On the contrary, you are able to buy fewer stocks when the market price is high. Ultimately, you average down your investment cost. If you do the lump sum investing, it is obvious that you would not be able to average down your investment as you would invest all your capital at once.

What is Averaging Down?

Averaging down is an investment strategy whereby an investor purchases additional shares of stock when its market price dips down. Since an investor can buy a higher number of stocks at a lower price, it lowers the average cost per stock, hence, referred to as averaging down. When the stock’s price, you purchased, increases after certain dips in the market, it is obvious that your profitability is going to get multifold. As price always increases after some correction depicted through the decrease in price, investors consider averaging down as one of the approaches for hefty returns over the haul.

However, one aspect that investors need to consider is the fact that averaging down is not profitable until the stock price starts increasing again. Hence, you ought to have the perseverance to hold the stock till the stock price starts showing ups in the market. It is a widely used term in value investing. Also referred to as falling knife investing, averaging down is considered to be an action that comes from our state of mind rather than a sound investment strategy.

If tried to analyze from another perspective, although, averaging down lowers the average cost of your investment, it might not always lead to great returns. It is because an investor might be investing in acquiring a larger share of a losing investment. Hence, the adequate study of the fundamentals of a company is vital. Considered to be the contrarian approach of investing, investors often go against prevailing investment trends when adopting averaging down strategy. If stock rebounds, investors soak the magnifying gains, however, magnifying losses are what the investors should be ready for – if stock continues to decline.

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Averaging Down Example

An example is vital to grasp the concept of any topic, especially the ones under the financial domain.

Suppose, you possess the capital of $20,000 and decided to perform averaging down rather than the lump sum investing.

Now, you buy 100 shares of stock at the prevailing market price of $100 leading to the total investment of $10,000.

You are left with the remaining $10,000 capital.

As the stock market depicts the volatility, if there are ups in the market, there exists downs for sure. Hence, taking into consideration such price fluctuation, say, the stock you previously bought has dipped down and now trading at the market at $75, 25$ lesser than the previous price you paid for. Considering it to be the perfect opportunity, you then decided to buy 100 shares of stock again implying the total investment to be $17,500 ($10,000 + $7500).

As the stock price has dropped, the stocks you bought are now worth $87.50 on average ($17500/200).

The next move the stock shows on the market determines whether you will be gaining or losing in your investment. Say, the stock’s price surged to $125, 25$ more than your very initial investment. Till this point, you managed to own 200 shares of stock and they are now worth $25000 (200*$125).

To sum up, you managed to buy a total of 200 shares of stock at the price of $17,500 and they are now worth $25,000 delivering the massive profit margin in between. That’s the power of averaging down.

In this example, I have illustrated the averaging down working in your favor after the price surged up. But what if the stock tumbles to $50 signifying the strong bearish trend in the market? In such a scenario your investment is now worth $10,000 (200*$50), way lesser than your total investment of $17,500.

Hence, it is to be noted that averaging down might or might not work in your favor and it all depends upon the market conditions. However, the market never always exemplifies the bearish trend, if your per stock price reaches $50, it may also reach $100+ in the coming days depicting a bullish trend too. So, rather than panicking about the contemporary market conditions, it is best advisable to hold until you grab the profit from the averaging down strategy.

However, you need to be informed that only stocks with strong fundamentals have the tendency to break the previous resistance and reach higher prices again. If you have selected the company with no analysis at all, forget about making hefty returns with averaging down strategy as such a company possesses uncertainty whether it is worth the investment or not.

When to Consider Averaging Down Your Investment?

Averaging down is considered to work best for the high-quality blue-chip stocks where there exists a low-to-zero probability of corporate bankruptcy. Such stocks possess a long-term track record, strong fundamentals, solid cash flows, sound management, and more of such rigid indicators, making them suitable stocks for averaging down. Even one of the greatest investors – Warren Buffet – has successfully used the averaging down strategy denoting it to be one of the viable strategies for value investors. However, investors/traders should not have the misconception that averaging down works only for value stocks. If you can hunt out the stocks with the probable price surge to correct its tumbling in the stock market, then you are good to go for the averaging down investing strategy.

Pros of Averaging Down

Lowers the average cost and increases the margin of safety in investing.

If you are able to buy low and sell high, later on, substantial profit is what you will be reaping over the period.

It makes an investor stay committed to investing their investment portfolio on a regular basis, as they have to analyze the market in order to accumulate the stocks with discounted prices in their portfolio.

Averaging down tends to push forth the investors to learn the fundamental analysis and the technical analysis skills to gauge the condition of a particular stock and assess whether the particular stock might be the compatible stock to target for averaging down, rather than investing blindfolded. Hence, acquiring such skills would turn investors towards sound investors with strong financial knowledge which would definitely leverage them over the haul.

Cons of Averaging Down

Losses magnify if stock continues to decline instead of the rebound. Investors might be victimized if they select the company facing a bleak future just for the sake of averaging down.

Under the circumstances of economic uncertainty, market volatility is higher making it tougher to opt for the averaging down investing strategy.

Continuous buying of additional shares for the sake of averaging down might impact your portfolio asset’s allocation. Your portfolio would overweight one particular sector. For instance, the majority of the portion would be dedicated to bank stocks or tech stocks, if you continuously average down these particular industry’s stocks only.

The third instance I just mentioned leads to the increment of risk exposure as it could create trouble when it comes to rebalancing your portfolio in an efficient manner.

Contrarian Investing Strategy

What is Averaging Up?

Averaging up – the exact opposite of averaging down – is an investment strategy whereby an investor purchases the additional shares of stock that s/he already acquired before, but at a higher price this time. Hence, it raises the average price of a stock. Averaging up works best in the rising market, or the bullish market as it indicates the strong possibility for the stock price to further surge in the coming days.

It depends solely upon the investors when it comes to the execution of averaging up investing strategy. Some investors perform averaging up based on their technical analysis whereas some tend to use the discipline strategy by planning their purchases to execute when a stock hits a certain price point providing the confirmation signal to such probable investors.

Investors need to assess the risk that averaging up possesses. They might be incurring huge losses if they bought the stocks once it hit the peak or before the stock started falling sharply. Averaging up might be perceived as counterintuitive to the majority of us as we are required to pour more capital into the stocks that are constantly increasing in value. Nevertheless, the winning potential is immense from the further surge of the price. A stock appearing to be cheap should not excite the investors as rather being undervalued, it might be representing the deteriorated fundamentals of the company. Hence, investors ought not to focus on the past return of capital, instead, should focus on the future return of the capital.

When a company delivers a compelling value proposition, it’s worth averaging up that particular stock or company. When investors tend to average up, the average cost increases, but not too fast. As a result, it allows you to funnel more capital to turn it into a potential big winner. Also known as pyramiding, averaging up although seems to be dedicating hefty capital than averaging down, however, coincides strongly in terms of returns to be allocated over the period.

Averaging Up Example

Suppose, you possess the capital of $20,000 and decided to perform averaging up rather than the lump sum investing.

Now, you buy 100 shares of stock at the prevailing market price of $50 leading to the total investment of $5000.

You are left with the remaining $15,000 capital.

As the stock market depicts the volatility, if there are downs in the market, there exists ups for sure. Hence, taking into consideration such price fluctuation, say, the stock you previously bought has hit another high and now trading at the market at $75, 25$ higher than the previous price you paid for. Being confident about the prospects of the particular, you then decided to buy 100 shares of stock again implying the total investment to be $12,500 ($5000 + $7500).

As the stock price has surged, the stocks you bought are now worth $62.50 on average ($12500/200).

The next move the stock shows on the stock market determines whether you will be gaining or losing in your investment. Say, the stock’s price again surged to $100, 50$ more than your very initial investment. Till this point, you managed to own 200 shares of stock and they are now worth $20000 (200*$100).

To sum up, you managed to buy a total of 200 shares of stock at the price of $12,500 and they are now worth $20,000. That’s how averaging up can leverage as you tend to continuously invest in the bullish trend.

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Why You Shouldn’t Be Afraid to Averaging Up in Good Stocks?

Everyone suggests buying low and selling high. What about buying high and selling even higher? You should never take a step back when it comes to including good stocks with strong fundamentals in your portfolio. In the hope of grabbing those stocks at lower prices, you could be missing out as its price might not trace back to the price point you wanted. Its stock price might go higher and higher with some minor correction in between the process.

Hence, rather than seeking out bargains, you ought to try to figure out the breakeven point, then accumulate the stocks with strong fundamentals, keep on doing so, and sell the entire position you acquired even higher. It is because good stocks depict a serious rally in the stock prices and averaging up can go on even for years. Thus, good stocks are worth averaging up.

Pros of Averaging Up

Buying at a higher price denotes the confidence of investors in the company’s business prospects thereby leading you the assurance towards that particular stock.

Investors tend to enjoy a hefty return during the bullish run even though they pay a higher price to acquire that particular stock.

Not only the stock price might be inclining, but the particular increment might be in tandem with earnings growth ultimately leveraging the investors with dividend returns as well.

Unlike averaging down, you do not have to wait and watch until the stock price increases again, rather, your trade is already profitable when the stock price breaks the previous resistance it made along with outweighing the previous price.

You do not worry about catching a falling knife as you are not buying the stock on its way down, instead, you are aligning with the viable company with a strong success track record agreeing to the potential of growth over the haul.

You cannot multifold your invested capital until it is doubled Hence, you should not be afraid to buy such stocks in a position where they can return you with hefty returns, be it 5-fold or 10-fold. Multi-bagger return is what the majority of investors leverage with averaging up an investment strategy.

Cons

There is definitely some sort of risks associated with averaging up, as things might not always work as we expected.

Unforeseeable events might hamper the business performing way better in the contemporary context adversely impacting the business.

You may end up paying too much for acquiring the stocks during the averaging up as it can go in vain if the businesses fail to grow as expected or start

Averaging Down vs. Averaging Up: Which One Should You Opt For?

Stock price fluctuation based on supply and demand is driven by the performance/health of the business. As an investor/trader, you ought to have the potential to figure out what actually is causing the stock’s price to surge or tumble in the market. If you are able to figure it out, you need not have to worry if the stock price tumbles as it might be the temporary short-term event that caused it, if not, you need to execute your trade or investment based on the underlying circumstances. Further, if the business is moving ahead signaling the strong fundamentals over the haul in recent years – consistently- it might be a signal to accumulate even on its growing stock price.

Hence, in the end, it all boils down to your preference. If you had figured out the actual reason behind the ups and downs in the stock price, you then need to implement your strategy either by averaging up or averaging down in the market. Both the strategies can work wonders for you and vice-versa.

From The Author:

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