Averaging down: A trading strategy to avoid or embrace?
Although the words, ‘average’ and ‘down’ can give a pessimistic first impression, an averaging down trading strategy could provide a profit for traders in the short and long term, though it can also potentially widen a loss.
Averaging down, as the name implies, lowers the average the trader paid for the asset. This reduces the price at which the investment could potentially return a profit – provided, of course, that the price bounces back. There is the risk that the price will continue to fall and leave investors with an even bigger loss.
What does averaging down mean in stocks?
Let’s say that you buy into XYZ, a popular blue chip utility stock, at £20 a share. You snap up 10 shares worth £200. The government announces it wants energy companies to cap prices and introduce an easy to understand basic tariff available to all.
Profits look a bit harder to make. The share price of XYZ utility company drops from £20 to £18. However, the long-term prospects seem solid, so you buy 10 more shares. This time your 20 shares have cost you £180.
A further drop in price enables you to buy 10 more shares at £16 a share, costing £160. Your average purchase price is now £18 a share.
This example of a stock averaging down strategy illustrates how you have trimmed the average cost of your share purchases. It also means that your stock has less to climb to show a profit. In this case, if the price rises above £18, you make money. The stock does not have to rise above your original purchase price of £20 for you to gain.
However, there is risk involved. Should the stock fall even further, you would be making a loss on even more shares. For example, say the shares fall to £10 and you lose confidence in their ability to rebound and decide to sell. You would be making a loss of £240 on your 30 shares, whereas it would have been a £100 loss if you hadn’t attempted the averaging down strategy, or even smaller if you’d sold earlier.
Buy and sell points
Both anchoring and loss aversion biases play their parts in helping traders decide when to buy and sell. Buying in at a certain point is often the ‘anchor’ level. It’s the level at which a trader measures their gains or losses relative to the price they originally paid.
In their view, all deviations from this figure are meaningful. However, this may overlook the long-term view when the broader economy is fundamentally better or worse, or when debt costs less or more.
If a trader focuses just on that anchor point without considering other factors, it is a bias, pure and simple.
Anchoring bias and loss aversion bias
Anchoring bias is particularly critical for traders looking at stocks or sectors they are not familiar with and have few reference points for. All options, price comparisons and price shifts are measured from the point at which the trader bought an asset.
Loss aversion can exert huge pressure not to hold onto a stock that’s falling in value. In an averaging down context, loss aversion may imply a belief that things will improve over the long term.
Your loss aversion bias might convince you to continue buying stock – using the average down strategy – when there is no rational reason for doing so. Traders should be willing to consider whether selling up and taking the loss on the chin could be the better option.
Anchoring bias may keep traders from selling until the price recovers to their initial purchase price, thereby negating the point of averaging down.
Focusing on different prices
In the previously discussed example, traditional anchoring bias would mean making the anchor point the initial £20 purchase price. In this case, if the share price never rises above £20, you will not sell, even though you could have made a profit at anything above £18 – the average price paid for the stock.
On the other hand, if your focus price is the last price paid, £16, you might sell too early when the price rises above £16, say, to £16.10. You will have recovered money on the last 10 shares bought but lost money on the other 20, making for an overall loss of £379.
If you avoid biases and successfully use the averaging down trading strategy, you would have sold at £18.10 and made a small profit of £3 of your total trades. At £18.50 you would have made a profit of £15, or just short of 2.8% of your total investment.
Averaging down means focusing on the average purchase price at which a position can be potentially profitably closed.
Give up that gut ‘anchor’ feeling
Trading averaging down means adding to a losing position but reducing the price at which a bounce-back returns a profit. This could work well for a long-term investor, when the share price has time to recover. For day traders, it would require a highly volatile asset that had large falls and rises in a single day.
Remember, disciplined trading relies upon the protection of losses. It is about mindful judgements, not gut feelings or hope. Averaging down is not always the best trading strategy.
Think of it from another angle – while you’re focusing on a falling asset, you could be missing trades with shares going in the other direction, such as ‘momentum’ or ‘trend’ stocks.
The trader’s priority is always to make money. While averaging down can work effectively for traders in certain conditions, such as when the market looks like it's about to turn, averaging down for the wrong reasons could be bad for your trading health.
Loss aversion bias
The averaging down trading strategy could be dangerous for traders suffering from loss aversion bias.
At its heart, loss aversion is an intense unwillingness to sell loss-making stocks or trades. Sometimes traders need to sell at a loss and put it down to experience. Loss aversion bias stops them from making that necessary, albeit painful, decision.
When loss aversion bias is aligned to the averaging down trading strategy (buying stocks that are losing value in hope they will turn around), it can become a toxic relationship – an unwillingness to cut your losses and move on, coupled with a lack of market interest.
If you buy more and more stock as the price falls, because you refuse to believe the evidence that this stock was fundamentally overvalued and has turned sour, you are not averaging down – you are potentially throwing away good money after bad.
Does the averaging down trading strategy work?
To be clear, buying or trading stocks when they are beaten down in price can work. Billionaire investor Warren Buffet has made a fortune from buying out-of-favour ‘value’ stocks.
Buffet has done so mainly in the right circumstances (although he also admits to making mistakes). That’s to say, when a stock is not threatened by technological obsolescence, litigation, mismanagement or any number of reasons that indicate a share or trade might be priced low because it’s a bad buy.
Averaging down works when a company’s fundamentals are sound and it appears to be undervalued on a range of basic valuation metrics.
Going the other way: Averaging up
Averaging up is the opposite path. Averaging up means you buy more shares as the price climbs.
Often averaging up means you buy fewer shares as the price climbs. This is a risk-averse strategy and there is evidence that it can be effective in the long-term.
Some claim that averaging up is less risky than averaging down, as traders are buying into stock with positive market sentiment driving its share price.
Here are a few factors to consider when deciding if the averaging down trading strategy is right for you:
Technical traders use rationality in their decision making. They use averaging down within stop loss levels in an effort to gain protection from a falling share price.
If you think there is room for averaging down in your medium or long-term portfolio, you could consider applying the strategy across a range of stocks such as blue chips with manageable debt levels and decent management, or sectors you have long-term confidence in, so that your risk is spread.
Averaging down has strong links with anchoring, loss aversion biases and the Martingale effect. The Martingale bias sees investors doubling their investment in a losing trade in a desperate attempt to ‘break even’ and recover.
Is averaging down a good strategy?
Averaging down can be a useful strategy for turning a profit and has worked successfully in the past. However, there are factors that should be considered before using it, such as whether there are substantial reasons to believe the price of the asset will rebound and if an investor is able to hold, potentially long term, until it recovers.
What happens when you average down on a stock?
When averaging down on a stock, a trader buys more shares when the price falls. This reduces the average they paid.
When to use averaging down?
When and if averaging down is the right strategy for you or not will depend on the kind of asset you’re trading, your biases, portfolio composition, investment goals and risk profile, among other factors. Different trading strategies will suit different investment goals with short or long-term focus. You should do your own research. And never invest money you cannot afford to lose.