Investors never average down. They say yes to buying dips but no to averaging down stocks! The lesson discusses how and why investors never average down but build wealth by selling losers to buy more winners. Successful investors do buy price dips but only average down in a rare limited circumstance. The opposite strategy, averaging up, can be a reliable money maker in the right circumstances. See the lesson for details.
What’s in this lesson for me?
Wealth Building Portfolio Management, lesson 5, explains why superior investors never average down but sell losers to buy winners for the most favorable portfolio returns. Links at the end guide you to related lessons if you want to learn more. The lesson explains the following points on averaging down and the rare case when this strategy works.
FAQ about averaging down
Investors never average down because they want to avoid losing money. The questions that follow have some overlap because the topic of averaging down is broad and all aspects are closely related. The answers to these questions and the rest of the lesson will help you understand averaging down, when to use it and when to avoid the risks.
What is averaging down?
Averaging down is a risky strategy of buying more stock after a significant price drop.
That lowers the cost per share, but the average cost is still higher than the market value. Although the difference to breakeven is smaller, that stock's portion of the portfolio and the total investment increase.
However, market records show that the prices of falling stocks often stall at the low or drop further. That can force investors to sell at a loss to recover what they can or sit on dead money.
Only risk using an averaging down strategy when buying a long-term winner, as only these stocks recover and rise in price enough to make the strategy profitable. That is the risk: are you buying a winner?
What happens when you average down?
Averaging down is buying more shares of a declining stock, hoping the price reverses.
Although buying more shares at a lower cost guarantees a lower average price, most losing stocks need significant change for a price turnaround. Meanwhile, this strategy shrinks the portfolio value as most losing stocks stagnate without substantial change.
Often, substantial changes involve refinancing, which dilutes existing shares further. That means additional devaluation, lower breakeven odds, and a poorer possibility of profit.
Conversely, wise investors sell as soon as they know they own a loser to avoid such challenges and prevent further declines in value.
By selling early, they revive the recovered capital and buy more winning stocks that increase portfolio value and maximize returns.
Do you lose money averaging down?
Averaging down is a risky investment strategy that can lead to significant financial losses and become a permanent money-losing disaster.
Essentially, it involves investing more money into a losing investment. Before using this strategy, it is essential to research why the stock price decreased and the possibility of it dropping further, weakening the portfolio even more.
While long-term contrarian investors may see value in averaging down, picking through losers to find success using this strategy is the exception rather than the rule.
Most investors do better by selling the losers to cut their losses and move on to find more profitable money-makers among the winning investments.
Is averaging down a bad strategy?
Averaging down the price of a stock is a high-risk strategy that can worsen an existing investment loss. Doing that means your net worth declines, as does portfolio performance and quality, while risk increases.
Although buying stocks on sale can be successful, averaging down on a proven loser rarely works. Instead, skilled investors sell those losers to buy more winning stocks.
The one averaging down exception is with large-well-established-high-quality stocks that have excellent fundamental value. Then, price dips can be a profit-making opportunity.
Other than that, never average down!
When does the averaging down strategy work?
Averaging down produces profits in exceptional circumstances and works best for market dips rather than a specific stock dip.
It can work when company fundamentals meet four critical criteria:
1. Large national or international company.
2. Track record of solid performance.
3. Minimal debts.
4. Growing cash flow.
Never average down if the circumstances and criteria of the market and stock do not align.
Is it better to average up or average down?
Savvy investors average up, which means buying more shares of a winning stock as it rises, avoiding losers, and increasing their net portfolio profit.
Investors average down by buying more shares of a declining stock to lower the average cost per share. By increasing the portion of the portfolio holding a losing investment, overall performance declines, leading to financial loss.
Some investors claim to succeed by averaging down. But that compounds the mistake and loss of buying more of a declining stock. Overall, betting on declining stocks is a losing strategy.
However, averaging down is an opportunity when the share price falls below the fundamental value. Identifying such stock-picking opportunities seriously challenges an investor's analytical and risk management skills.
Average Up Average Down Summarized
Averaging up or averaging down when investing depends on investment strategy, risk tolerance, and the specific circumstances surrounding the investment.
Averaging Down means the investor buys more of a stock or asset as the price decreases when the investor believes the fundamental value of the investment is higher. However, investors need analytical and risk management skills to differentiate between a temporary dip in price and a declining investment with deteriorating prospects. Averaging down amplifies losses as the investment declines, requiring careful analysis and risk management.
Averaging Up means investors buy more of a stock as the price increases as momentum investors do. Buying more as an investment winner continues to perform well and maximizes profits as the trend continues.
This strategy carries the risk of buying at inflated prices or just before the trend reverses so requires careful monitoring of market trends and disciplined risk management.
Both strategies can be effective depending on the specific circumstances and the investment goals. Both require thorough research, risk management, and a well-defined investment strategy.
Do not play high risk odds. Investors never average down...but buy the dip!
Never averaging down is one the most valuable skills of superior investors. Investors that sell losers and buy more winners improve their portfolio returns. We look at both successful rides through price dips and price drops that happened without any sign of significant recovery. Averaging down on some dips would have worked well.
Problems rise when trying to average down does not work but becomes a trap for investment money. Get it wrong and you have to deal with a very costly mistake. Sometimes stocks do fall in a hole and never climb out. Sometimes a stock that declines never recovers. Stocks can die as worthless investments.
Yes, to dips but no to averaging down!
Even when there is a price recovery it can take years for an average down strategy to work. In the meantime, that money is effectively dead. Putting the money to work productively elsewhere pays off every time! That move guarantees the odds work in your favor.
To recap, if the economy is positive and the market is positive we then turn to examine each specific company. If there are no substantive negative facts, we stay in through price dips. If the facts are substantive and negative, we immediately sell. Take the loss and get the funds to work in other stocks, making us more money by riding a growing stock.
We do not and cannot know it all. Ever. Things happen, things change. Even when an investor is ready and willing to ride through a dip, it can have a bad outcome. Significant negative news can instantly change the picture. We get surprised. We have it wrong. Our prudent choice is that we immediately sell.
Change teams but don't average down
One of the great things about the stock market is our ability to change teams. When we know we are on the wrong or losing side we can change teams. Sell the loser and buy the winner.
Averaging down significantly increases risk. If we are wrong on a decision to average down, we kill our investment performance. It goes beyond the single stock involved. A wrong decision can devastate other investment returns or even destroy portfolios.
Far better odds favor our overall portfolio performance by not following the average down strategy. In most cases, even when averaging down works in the case of a single stock, there is a negative effect on the portfolio.
Averaging down always impairs overall portfolio performance. This happens because more resources are going into a weak position. Using the opposite strategy of putting the resources into strong positions disproportionately increases your portfolio performance. When that is possible who wants an impaired portfolio?
Remove the averaging down strategy out of your investment management toolkit. That will improve your portfolio performance odds, and accelerate portfolio performance.
Averaging up builds portfolio profits
Besides avoiding the loss of averaging down, for a very effective money-making strategy, investors can do the opposite when circumstances allow, which means averaging up, . To average up, investors buy more shares as the share price rises. This does raise the average price paid for the total number of shares while the position grows, but the greater overall profits make that well worthwhile.
This attractive money-making strategy takes advantage of price momentum in a stock or the market. By using this strategy as the stock price rises and more buyers are attracted, investors can set themselves up for a one-two portfolio growth injection.
One-two impact grows portfolios
The one-two impact is, first, the value of each share that is owned increases as more shares are bought while prices rise. And, second, as buying continues the holding grows to become an ever-larger portion of the portfolio. As a result, the portfolio growth increases because a larger portion of it contains an outperforming stock!
10 Baggers start as a one bagger
Investors that dream of winning investments can hope to buy a 10-bagger, which is a stock that goes up in value by 10 times! It does happen! And owning a 10-bagger can have a spectacular impact on the value of a portfolio!
But that takes time, and before these stocks were 10-baggers, they were 5-baggers, and before that, they were 2 baggers. So, to benefit from such a ride means buying more when the stock is a 2 bagger, and then a 5 bagger, and so on. Such stock has to double before it can go to 5 times higher in value, and then 10 times higher in value.
Averaging up does have risks
But, as always, there are risks. Once the peak price is reached, this momentum-riding party is over. That means averaging up has the risk of a greater loss if you are buying just before the price or market drops. But until then, the party continues and profits continue growing. Like every stock market strategy, averaging up is not foolproof. But it can quickly pile up profits for alert investors in positive markets.
Because it is a momentum play, the best averaging up results come in positive markets with both the stock price and the market rising. That good market environment means most investors have a positive outlook. They are optimistic, and happy investors do not sell. They buy!
As a stock rises in price the market cap or total value of the company also rises. One result is that the company is viewed as a larger company. And larger companies attract the attention of more investors. Once the number of buyers grows, the herd momentum grows as both the sale volume and prices rise. When the herd shows interest, prices can soar!
Momentum ignores losing stocks
Struggling or problem companies don’t get invited to the momentum party. While there are no guarantees, most often, waves of stock buying push better performing companies to higher prices. Underperforming companies, including any with falling prices, don’t get into the momentum party.
Although ironic, as prices rise, more money chases fewer companies to drive those share prices higher yet. More and more money goes to fewer and fewer in the wave of momentum which powers the race for profit. And every bit of buying helps investors who average up, make more money.
Why this lesson matters
Learning to never average down adopts a valuable strategy of a superior investor. Selling losers to buy more winners immediately improves returns for investors. Any investor adopting this strategy will improve their returns.
Key take away points from lesson 4,
Investors never average down:
Investors never average down; they say yes to dips but no averaging down!
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Wealth Building Portfolio Management lessons:
Introduction to portfolio management Lesson 1
Pyramid portfolio wealth building Lesson 2
How investors buy dips Lesson 3
Distracted investing misses profits Lesson 4
Investors never average down Lesson 5
Market patterns repeat repeat repeat Lesson 6
Research confirms investment counts matter Lesson 7
Portfolio measurements to size positions Lesson 8
Growth protects investing profits Lesson 9
Winston Churchill said crisis = opportunity Lesson 10
Weeding your investment portfolio Lesson 11
Next lesson 6:
Research confirms investment counts matter
Have a prosperous investor day!
Bryan
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Lesson code 302.05.
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