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.