Averaging Down

Definition

The term averaging down refers to an investment strategy that involves buying additional shares of stock at a lower price than originally paid.  Averaging down effectively lowers the average price paid per share of stock.

Explanation

An investment strategy that's oftentimes grounded in myth is averaging down.  The concept can apply to the purchase of stock as well as options.  The process involves buying additional shares of stock when the stock's price is falling.  By doing so, the investor's average price per share is lowered.  The investor hopes the stock's price will eventually rise, and the lower average price will result in additional profits.

Unfortunately, when a stock's price is falling it's oftentimes the result of information that lowers the perceived or fundamental value of the security.  In fact, when a stock's price falls there is no guarantee it will rise in the near term.  Following an averaging down strategy also results in the investor holding additional shares of the same stock, which may result in an overweighting of the security in their portfolio.

Example

An investor purchased 100 shares of Company ABC's common stock at $40.00 per share.  Shortly afterwards, the price of Company ABC's stock declined to $20.00 per share.  The investor subscribes to the averaging down strategy and purchases an additional 100 shares of Company ABC's stock at $20.00 per share, bringing the average cost to:

= (100 shares x $40.00 per share + 100 shares x $20.00 per share) / 200 shares
= ($4,000 + $2,000) / 200 shares, or $30.00 per share

Related Terms

calendar spread, butterfly spread, box spread, backspread