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Averaging down is an investment strategy in which an investor purchases additional shares or other assets at a lower price than their initial purchase price. This strategy is employed when the price of the asset has declined after the investor’s initial purchase. Through buying more of the asset at a lower cost, the average cost per unit or share decreases. Averaging down can be applied to various types of investments, including stocks, bonds, commodities, and cryptocurrencies.
This article provides an example of what averaging down may look like and explores some of the considerations that must be taken into account prior to implementing such a strategy.
Averaging Down – An Example
To illustrate the principle of averaging down, consider the following example. An investor believes in the long-term potential of an AI company’s stock, ABC Tech Pty Ltd, and initially purchases 100 shares at $50 per share, resulting in a total investment of $5,000. However, over the next few months, the stock price declines due to market volatility and concerns about the company’s financial performance.
Averaging Down actioned
After a few months, the stock’s price has fallen to $40 per share. The investor believes that the price drop is temporary. Rather than selling the shares at a loss of $1,000, the investor decides to employ an averaging-down strategy.
The investor purchases an additional 100 shares of ABC Tech Pty Ltd at the current price of $40 per share. Here’s how the investment looks after the additional purchase:
The Opportunity in Averaging Down
With the average cost per share now reduced from $50 to $45, a profit will be realized if the stock’s price eventually rebounds and exceeds $45 per share. If the stock price increases to $55 per share, here is the updated financial picture:
Risks of Averaging Down
However, if the stock price declines further to $35, the situation would be as follows:
So rather than an opportunity realised there is a compounding of the losses.
This can be exaggerated further should additional averaging down purchases be made at the new lower price, which some who use this strategy would subsequently action.
What this example aims to illustrate is that despite any potential advantage, merely buying more of an asset because its price has declined doesn’t guarantee that the asset’s value will eventually recover. Without proper research and analysis, investors might be investing in an asset with poor long-term prospects. So, the key message is that this strategy should be based on additional considerations that must form part of the decision making.
Key Considerations for Averaging Down
As we have outlined, averaging down can be a tactical move when executed with careful consideration of the asset’s fundamentals and market trends. It can be particularly effective for investors with a long-term perspective who believe in the asset’s long-term potential. However, the following represent some of the considerations that must be at the forefront of any such decision.
Averaging down can be useful if applied thoughtfully and with a clear risk management plan. However, it comes with its own set of risks, and investors must carefully consider their risk tolerance, investment goals, and market conditions before deciding to implement this strategy. As always, it’s crucial to maintain a well thought out portfolio, conduct thorough research, and avoid emotional decision-making.
Disclaimer: Articles are from GO Markets analysts and contributors and are based on their independent analysis or personal experiences. Views, opinions or trading styles expressed are their own, and should not be taken as either representative of or shared by GO Markets. Advice, if any, is of a ‘general’ nature and not based on your personal objectives, financial situation or needs. Consider how appropriate the advice, if any, is to your objectives, financial situation and needs, before acting on the advice. If the advice relates to acquiring a particular financial product, you should obtain and consider the Product Disclosure Statement (PDS) and Financial Services Guide (FSG) for that product before making any decisions.