Downward average: how to use this investment strategy
Stocks are falling and you may be seeing your account drop every day. This might leave you with questions. What to do when the stock market goes down? Should you sell everything and go cash? What is the best thing to do in the long term? Your best bet may be an average down.
Keeping your emotions in check is an important part of being a successful investor. For example, the famous investor Warren Buffett once said, “The most important quality for an investor is temperament, not intellect.” In other words, don’t buy or sell stocks just because the market is up or down.
Many investors set rules for buying or selling stocks before making a trade. This way, emotion is removed from their decision making. For example, an investor may find a stock they like. Instead of buying it right away, they value the stock. Later, they will buy it when the stock drops below a good price, and vice versa. When the stock reaches a certain price, they sell it.
It’s nice to hold them and watch your account grow as the stock goes up. It gets harder when stocks go down and you feel bad. Another strategy investors can use when the going gets tough is average dips.
Average inventory down
Suppose you bought shares of a company you like at a good price. Even if you bought at a good price, that doesn’t mean the stock price will go up right away. Sometimes the stock price can go down a lot. While this won’t make you feel good in the short term, it can be a great opportunity to average out in the long run.
If you’ve done your homework correctly, the downside average can be a great source of long-term returns. For example, let’s say you bought a share of XYZ Company for $100. Later, the share drops to $50. This does not necessarily mean that your homework was incorrect. In fact, if your homework is correct, the stock price drop is an opportunity.
Say you are able to swallow your pride and buy another share of XYZ Company for $50. Instead of having one $100 stock, you now have two stocks. One share for $100 and one for $50. Your average price is $87.50 ($175 total price/two shares). In other words, you’ve averaged down.
Now, let’s say it’s a year later, and shares of XYZ Company have recovered to $100 per share. Since you could keep your emotions in check, you have two stocks worth $100 each or $200. Remember that you bought your two shares for a total of $175. So you have a return over the holding period of 14.3% ($0 gain on the first stock + $25 gain on the second stock/total investment of $175).
It is important to note that the stock price has not exceeded the $100 level at which you bought your first stock! If you hadn’t averaged down, your return would be 0%.
Is average down a good investment strategy?
In short, yes. Even if the stocks you average don’t recover. For example, let’s say the investor in the previous example got their homework wrong, the company did poorly, and the stock continued to fall. If that were to happen, your returns would be better if you never averaged down.
Say the stock slipped to $25. The investor would have invested a total of $175. They would have a loss of $50 on the first share and a loss of $50 on the second share. So the holding period return would be -71.4% ($75 loss on the first stock + $50 loss on the second stock / $175).
If they hadn’t averaged down, they would have bought a stock at $100 with a loss of $75 or -75% ($75 loss/$100 investment).
The previous example is obviously not ideal, but it shows that lowering the average can work both ways. Hopefully the stock in the second example recovers. If not, and the stock drops to $0, all bets are off! All returns go to zero.
Readers should also keep in mind that averaging takes more money out of your account. As such, these examples do not reflect the performance of your entire portfolio.
Recurring purchases by fixed sums
Some investors make regular monthly contributions to their investment accounts like a Roth IRA or 401(k). No matter what the market does, they invest their money regularly. Regular contributions are a great way to remove emotion from your decision-making.
It’s great when stocks, mutual funds or ETFs go up! On the other hand, you lower the average when these investments go down, and you may not realize it. The important thing is to stick with your strategy no matter what the market does.
Remember that stocks may continue to rise over the long term. The downside average can be a good investment strategy, eliminating emotions and giving you the opportunity to improve your returns.
BJ Cook is a lifelong stock market nerd. He has held several positions in the world of equity research and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him seeking new ideas of investment. Outside of the investing community, BJ is a die-hard Cubs fan.