Averaging up or averaging down means buying more shares in a stock you already own. It can be used for going long, or for short selling. Here’s how it works and what to consider.
Ask yourself this: when is buying more shares in a company you’ve already invested in a good idea? Is it better to buy when the price is going up or when it’s falling, or do both strategies have their good and bad points?
There is no right and wrong answer. Investing in more shares at a higher price than your original investment is known as averaging up as the new shares cost more than the ones you have bought previously so the average price per share has increased.
Conversely, if the share price is falling and you add to your investment, the average price will now be lower. This is known as averaging down. If we’re honest, there are more fans of averaging up than averaging down.
Great names in investing, such as Warren Buffett, use averaging up over long periods of sustainable share price growth. But the techniques can also be used within day trades – adding to a still open position.
Let’s look in more detail.
You have decided to buy some more shares in that company that seems to be doing well. It is a strong bull market. Your original investment was 1,000 shares at £10 a share.
The pyramid technique is a recognised way of averaging up. So rather than spending your investment pot in one go, you start with a proportion and then add to your holding in increments, each one about half the total volume of the previous one.
Say the price is now £12.50 a share. To buy half as many shares again, you would pay £6,250 for 500 shares. This would make the average price of all the shares you own about £10.83. As the market rises again you pick up another 250 shares at £15, for a total on £3,750. You have now spent £20,000 on 1,750 shares, making the average price £11.43.
By building ever smaller shareholdings on top of larger ones we get the pyramid effect.
Advantages of averaging up
Risk averse investors control the average price that they pay for stocks by making smaller and smaller purchases as the price gets higher, protecting themselves from price volatility.
If, in our example, instead of averaging up, the investor had bought the same amount each time - 1,000 shares at £12.50 and a further 1,000 shares at £15, the average share price would be £12.50.
Had price volatility driven the price down to £12.40, that would be loss-making territory. Because we averaged up, our average share price still puts us in a profit-taking position.
If the first trade turns bad, risk is limited as you’ve not bought your full position in one go. You build up to your target holding only as the price continue to move in your chosen direction.
This work's for both long and short positions. And it can work in intra-day trading, allowing a proactive investor to increase a long or short position as the price moves successfully in the right direction.
Downsides of averaging up
The higher transaction cost of the additional shares is one of the downsides, although fans of averaging up would say that the increased risk control outweighs the increased cost.
And the share price can change direction. It could mean that the shares bought at a higher price do not make a profit whereas if all the shares had been bought in one go at the lowest price there would have been a bigger profit.
Other negatives include the fact that cash earmarked for the next level of the pyramid might be just sitting idle when it could have been earning money. There’s also the downside of having to pay broker’s commission a number of times rather than just the once.
While averaging up tends to involve buying increments of half as much as the previous investment – to create the pyramid effect – averaging down doesn’t.
Averaging down tends to involve buying the same number of shares as the original holding, so with an initial holding of 1,000 shares at £10 you might buy another 1,000 shares when the price falls to £5 meaning you now own 2,000 shares with an average cost of £7.50.
But there’s more flexibility with averaging down. Some people buy different volumes, rather than the same quantity each time. The key risk, however, is that you are adding to a losing position when the price has moved against you.
In the long example, if all goes well and the stock rebounds to £15, instead of making a profit of £5 a share on your original investment you will have made £7.50 a share on the combined investment. You would also have started to have made a profit when the price bounced above £7.50 not the £10 of the original investment.
While Benjamin Graham in the Intelligent Investor said that investors should see downturns as a chance to buy stock at discount prices, averaging down has far fewer fans than averaging up. Especially in intra-day trading.
Averaging down considerations
There are many things to think of before adding more of that stock with the falling price.
First there is the momentum effect, a known trading pattern followed by some key investors. Once a momentum has started, rising share prices tend to keep rising; falling ones tend to keep falling. Adding a stock that has downward momentum may not be sensible.
You have to question whether you are throwing good money after bad and whether there is a better home for your money than buying up more of a stock that is in free fall.
Is the company in terminal decline or is there a valid reason for a short-term downturn in fortune? It can be hard sometimes to tell. Be much more cautious if it is a bull market and your shares are falling in price.
To benefit from averaging down you have to be willing to hold on to the share long enough for the price to go up to make your profit. It is a buying opportunity so long as the company has good long-term prospects.
To average down or not?
The dilemma, even for a long-term investor, of whether to average down a stock can be seen with a company whose shares have not been doing well recently.
The Restaurant Group’s share price has more than halved since the start of 2016. It owns brands including Frankie & Benny’s, Chiquito and Garfunkel’s.
It is closing dozens of outlets, cutting costs and looking to revamp its Frankie and Benny’s Italian-style chain which has provided the majority of its profits. It is also trying to win back customers by offering large discounts.
TRG’s interim report this year says: “We continue to expect to deliver an adjusted profit before tax outcome for the full year in-line with current market expectations.”
And Questor in the Daily Telegraph said in June 2017: “The firm has very little debt and banking covenants are under no threat, so time is on the side of both management and investors.”
But the restaurant industry has been badly affected by inflation, the rise in the national living wage and rising business rates. Other restaurant chains have closed outlets recently include the gourmet burger chain Byron.
Would it be a good time to average down if you had bought shares in the company previously?
Are you rational?
Analysing the goings on at a company and how its sector as a whole is doing is the logical way of deciding where to put your money. But not all investment decisions are logical and people often let bias prevail against logic.
Putting more money into a stock might just be because you believe you are on a roll. But being on a roll is also known as the hot hand fallacy after research based on basketball players.
Successfully sinking a number of shots in a row might lead a player to believe that he is on fire, that he has hot hands. But research by Amos, Gilovich and Vallone found that whether a shot was successful or not was reliably random and not affected by how confident the player was.
Daniel Kahneman, in his bestselling book, Thinking, Fast and Slow, agrees: “The hot hand is entirely in the eye of the beholders, who are consistently too quick to perceive order and causality in randomness. The hot hand is a massive and widespread cognitive illusion.”
Another thing to be wary of is what is known as recency bias. Are you giving too much weight to what has happened recently in the markets? People can place far too much importance on recent events and forget to place them in context.
So your brain tells you that the stock has always risen in the time that you have held it and the market has been on the up since you held it, so it is always going to go up. Only this cannot always have been the case and knowing, as the small print says, that “investments can go down as well as up” should always be factored in.
Down, down, deeper and down
What if the price of your investment is going down? It would be sensible to cut your losses and put the money into another stock that is on the up but somehow you can’t let go and not only are you holding on to the stock you are considering averaging down.
If there are no sound reasons for holding on to the stock you may also be letting your biases prevail. Closely related to the hot hand fallacy is gambler’s fallacy – the belief that a losing streak can’t keep going on for ever. You think the price of the stock has change direction and go up only because it has fallen for so long.
The trouble is, with shares you are not waiting for red to come up after a string of blacks, you are dealing with a company whose shares may well be falling for a perfectly sound reason. It a false hope, based on your personal biases.
Another reason you may be reluctant to sell is what you perceive the shares to be worth. You may think that they should get back up to the highest value they have been over the past year or reach the price you paid for the original stock again.
This is anchoring bias – relying too much on information that possibly was only a rule of thumb in the first place and has quite likely been superseded.
Human evolution may also be holding you back. Research by Kahneman and Tversky has shown that people prefer avoiding a loss to receiving a gain. This was perfectly understandable when losing a precious resource could threaten our very well-being.
But it can be an impediment to maximising your returns. Michael Pompian, author of Behavioural Finance and Wealth Management says: “You're waiting in a bad investment because you can't face the fact that you're having to take the loss. The more rational approach is to take your loss, record the tax loss and move on to something that has better prospects."
The law of averages
Buying up more of a stock that you already own can be a good investment but only if you have done your research and established that pride, sentiment or any other psychological bias is not behind your decision.