Averaging Up or Down

Averaging up, or down, can be a solid tactic to maximize your profits.  It's also a very dangerous one.

Let's say you have purchased 100 shares of Apple at an average cost of $400 per share.  If your reason for buying, or your "thesis" is correct, then as the share price drops, you actually have to like the stock more.  This applies even more greatly, if an outside force is impacting the market, and your stock, is poised to beat earnings.

If Apple's stock price were to sell-off, rather than sell the stock, a keen buyer, may average down, by buying an additional 200 shares.  That would mean this person currently owns 300 shares at an average cost of $366.66.  This is the definition of "averaging down".  This buyer now owns more stock, but at a lower cost basis.  They could sell the stock if it get back to even, or ride all 300 shares to even higher profits.  They don't however, have to wait until $400 to be back to even, that comes at $366.66.  

It works the other way too.  "Averaging up" means buying more shares on the way up.  I prefer averaging up because you are chasing a stock that is already going the direction you want, but both methods while completely necessary to good investing, carry risk.

That person in the first example, who bought a 100 shares of Apple, looked at the fundamentals, listened to the conference call, studied the technicals, and all that happened, was they lost $50 per share.  This can happen to different stocks, and different people, for different reasons.  I can't really blame you if you make a good buy, and the next day, an unexpected market event, starts a bear rally.  

That's why it's right to average down, when you are sure the stock is cheap, and the general market activity is a bunch of hocus-pocus, that doesn't affect your stock, on a day to day basis.  This stock must have great qualities.  Earnings, earnings growth, possibly a dividend for support, and visibility, are all needed to average down safely.  

Most of the time, you'll just be plain wrong.  The stock was wrong.  The timing was wrong.  The investment amount was wrong.  A whole bunch of the time, when you evaluate a stock, and it goes down, it is correct to sell.  Compare your stock to the overall market, if it's under-performing it for any length of time, you should have a good idea why.  You can always sell, sit on the sidelines with your money, and then come back in at a lower price, and when the stock is finding support technically.  Most of the time, you'll probably just move on to better things.

You can't just sell the stock every time one falls though, because there is no doubt, as the price falls, the stock gets cheaper.  I know doesn't sound very ground breaking, but it is.  That 200 shares at $350, are a way better buy, than the 100 shares at $400, if the company will rebound eventually, and appreciate in value.  

$350 shares, are 87.5% of the $400 price.  That's 12.5% savings on those shares.  It's so much easier to make money in a stock, when you get the correct "entry price".  It's not a bad idea to dip your toe into a stock, knowing you'd like to increase your position at a later date.  This way you can average down, or up, as the situation demands it.  You won't always be able to get in, at the perfect price, so having the ability to buy more shares is a back up plan.

When you are averaging down, you are chasing a stock that is moving lower.  When averaging up, you are increasing your overall cost basis, in the hopes of even further profits.  Both those are extremely risking strategies unless you are correct about the longterm fundamentals of the business.  The good news is, if you are correct about direction the stock will take, you can't go wrong with either strategy.  

This is why "Cash is King"...