STOCK MARKET TECHNIQUES: AVERAGING
Averaging down in stock market lingo means purchasing additional units of stocks already held by the investor after the price of stock declines. This eventually results in a drop in the average cost per share that was purchased by the investor. It is one of the most trusted share market tips or techniques that investors use to multiply their returns.
Why do investors average down a loss?
Averaging down is an alternative to sharing shares at a loss. It reinforces the “buy at a low price, sells at a high price" mentality used in stock trading. Stockholders like to hold on to their shares rather than sell them. This feeling of attachment makes them use several stock market techniques to retain their shares instead of selling them at loss.
Sometimes, even stocks of good companies can drop down owing to market forces. It’s usually the confidence in the company’s stocks and their intrinsic value that makes the investors stay. They believe that there is a potential for good investments later even if there’s a drop in price at the moment.
But is averaging down a good idea, or is it a mistake?
The answer is quite simple. If the share returns to a higher price due to its intrinsic value, it was a good strategy. If the price keeps falling down, it was bad judgment.
Proponents of this method consider it as a good way to hold the stock and accumulate wealth (such is their bargain-hunting mentality), whereas opponents argue it's just wasting good money after bad.
The radical conflict of opinion brings one into a quandary- to average down or not to average down?
Averaging down is connected with luck. The stock market is quite unpredictable and the prospect of an increase in the price of the stock is what investors hope for. After averaging down, if the price decreases further and there are high chances of that, it is just a bad investment. In that case, investors can switch to other stock tips.
So let's have a good look at the advantage and disadvantages of averaging down and then you can comprehend if it is beneficial for you.
The main advantage of averaging down is that it can bring down the average cost substantially. Supposing that the stock turns around the investor would actually earn more than he would have if the stock was not averaged down, as the breakeven point lowers.
In case the stock doesn’t rebound and instead keeps falling, the losses will increase.
Another inherent disadvantage of this method is that it messes up with the investor's portfolio. Since it involves the purchase of extra stocks, it will reflect highly on the portfolio. For instance, averaging down a bank's stock can increase the weighting of stock from 20% to 35%, which indicates a higher-than-desired exposure of investors to bank stocks.
Hence, it is extremely important to assess the risk before averaging a stock down or else the trader should use other stock tips.
If you are investing in a company and you believe it's financially sound, averaging down makes sense. Otherwise, averaging down doesn't make much sense. It is better to take a loss before it transforms into a bigger loss. It would be more prudent to sell the original stock and move on to the next trade. So, averaging is one of the most important share market tips that investors can rely on.