Stocks are falling, and you may be watching your account fall every day. That might leave you with questions. What should you do when the stock market is falling? Should you sell everything and go to cash? What is the best thing to do in the long run? Your best bet may be averaging down.
Keeping your emotions in check is a big part of being a successful investor. For instance, 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 to buy or sell stocks before they make a trade. That way, emotion is removed from their decision-making. For instance, an investor may find a stock that they like. Instead of buying it right away, they value the stock. Later, they’ll buy it when the stock falls below a good price, the same in reverse. When the stock rises to a certain price, they sell it.
It feels great to hold them and watch your account grow when stocks are going up. It becomes more difficult when stocks are going down, and you feel terrible. Another strategy that investors can use when the going gets tough is averaging down.
Averaging Down Stocks
Say you bought shares of a company you like at a good price. Even though you bought at a good price, that doesn’t mean the stock price will rise right away. Sometimes the stock price may go down a lot. Though it won’t make you feel great in the short term, it can be a great chance to average down for the long term.
If you did your homework correctly, averaging down can be a great source of long-term returns. For instance, say you bought a share of XYZ company for $100. Later, the share falls to $50. That doesn’t necessarily mean your homework was incorrect. In fact, if your homework is correct, the fall in share price is an opportunity.
Say you’re able to swallow your pride and buy another share of XYZ Company for $50. Instead of having one share at $100, you now have two shares. One share for $100 and one for $50. Your average price is $87.50 ($175 total price/two shares). In other words, you averaged down.
Now, say it’s a year later, and shares of XYZ company have recovered back to $100 per share. Since you could keep your emotions under control, you have two shares worth $100 each or $200. Remember that you bought your two shares for a total of $175. So, you have a holding period return of 14.3% ($0 gain on the first share + $25 gain on the second share/$175 total investment).
It’s important to note that the share price has not risen above the $100 level where you bought your first share! Had you not averaged down, your return would be 0%.
Is Averaging Down a Good Investment Strategy?
In short, yes. Even if the stocks that you average down don’t recover. For example, 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 slid 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 share + $50 loss on the second share/$175).
Had they not averaged down, they would have one share bought at $100 with a loss of $75 or -75% ($75 loss/$100 investment).
The previous example is obviously not ideal, but it shows that averaging down can work in both directions. Hopefully, the stock in the second example recovers. If not, and the stock goes to $0, all bets are off! All returns go to zero.
Readers should also keep in mind that averaging down takes up more of the money in your account. So, these examples don’t reflect the return on your whole portfolio.
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 emotions from your decision-making.
That’s great when the stocks, mutual funds or ETFs are going up! On the other hand, you’re averaging down when those investments are falling, and you may not realize it. The important thing is to stick to your strategy no matter what the market is doing.
Remember, stocks can continue to rise over the long-term. Averaging down can be a good investment strategy, remove emotions and give you the chance to improve your returns.
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.