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Monday, November 21, 2011

Averaging Down - Good Strategy or Bad?

Averaging down is a strategy to lower your average cost in a stock that has dropped in price. Is this a good idea or throwing good money after bad?

The answer depends on several factors. First, let us describe how it works. You buy 500 shares at Rs 50 per share, but the stock drops to Rs 46 per share. You then buy another 500 shares at Rs 46 per share, which lowers your average price to Rs 48 per share.

Admittedly, this is a simple example, but you get the idea.

Good Strategy or Bad?

Now, is this a good strategy or not? If the stock rebounds to Rs60 per share, then it was a great strategy. However, if the stock continues falling, you have to decide to keep averaging down or bail out and take a loss.

Which brings us back to the question, is averaging down a good strategy or not? Before we can answer that question, we need to decide if we are investing in a stock or a company. The distinction is very important.

Investing in Stock: If you are investing in a stock, you look for buy and sell signals based on a number of indicators. Your goal is to make money on the trade and you have no real interest in the underlying company other than how it might be affected by market, news or economic changes.

In most cases, you don’t know enough about the underlying company to determine if a drop in price is temporary or a reflection of a serious problem. Your best course of action when investing in a stock (as opposed to a company) is to cut your losses at no more than 7%. When the stock drops that much, sell and move on to the next deal.

Investing in a Company: If you are investing in a company (as opposed to a stock), you have done your homework and know what’s going on within the firm and its industry. You should know if a drop in the stock’s price is temporary or sign of trouble.

If you truly believe in the company, averaging down may make sense if you want to increase your holdings in the company. Accumulating more stock at a lower price makes sense if you plan to hold it for a long period.

This is not a strategy you should employ lightly. If there is a heavy volume of selling against the company, you may want to ask yourself if they know something you don’t. The “they” is this case will almost certainly be mutual funds and institutional investors.

Swimming against the current can sometimes prove profitable, but it can also get you swept over the waterfall.

Hence, if you’re playing stocks, averaging down probably doesn’t make any sense. Take a small loss before it becomes a big loss and move on to the next trade.

If you invest in companies, averaging down may make sense if you want to accumulate more shares and are convinced the company is fundamentally sound.