Average down is a practice used by investors when a stock position loses value. When the stock price falls, instead of panicking or selling shares, an investor buys additional shares of the same stock. This decreases the cost basis, or the average original purchase price for the stock, including fees. The average down formula may have a beneficial psychological effect for an investor because his losses appear to have been mitigated, but the purpose is that the shares will hopefully eventually rise, making the investment profitable.
Buying additional shares of a sunken investment is only a viable option if the company shows promise of turning the stock price around at some point in the future. For example, a one-time event, such as missing profit expectations established by Wall Street or having a drug rejected from a clinical trial, may send shares tumbling temporarily. Once a company demonstrates its ability to grow its profits or improve its drug offering so that it will eventually come to market, the stock will most likely climb, and reward investors in the end.
There are times when an investor may plan to average down ahead of time. He may allocate a sum of money for the stock, but decide not to buy shares all at once for one reason or another. For instance, if the economy is showing signs of weakness, an investor might want to enter the market slowly. The average down formula in this scenario makes sense. As long as the economy begins showing signs of stabilizing, the investor can wait for the stock to decline in price, perhaps as part of a broader market sell off, and allocate the rest of the money into the stock.
If a stock, however, has been displaying signs of ongoing weakness, the option to average down might not be the best choice. Signs of weakness may include a stock price touching or dropping below its 52-week low point. If a company is under-performing other similarly structured entities in the same sector, there is probably something company-specific weighing on the stock price rather than an industry-wide trend.
Once it is determined that a stock is showing weakness, rather than to average down another option might be to seek out a different stock investment altogether. Researching potential investments can lead to increased options, including several stocks with similar business models that are trading in a similar range. Rather than taking a risk with a stock that has already disappointed once, it might pay off to use the funds that would have been reinvested in the losing stock and place them with another company that shows promise for rising profits and growth.
