Definition
“Average Down” is a financial term used when an investor buys more of a particular stock at a lower price than they initially paid, therefore reducing the average cost per share. This strategy is used when the stock’s value has fallen in a bid to lower the average purchase cost if the value increases later. It’s a risk management approach employed in periods of market downturn.
Key Takeaways
- Average Down refers to the process of buying additional shares of a stock at lower price points than the original purchase price, thus reducing the average cost per share.
- This investment strategy is used in the belief that the stock price will eventually rebound, allowing the investor to profit from the lower average cost of their shares. However, it is essentially a bet against market trend and could involve higher risk.
- It can be a viable strategy for long-term investments, or those involving blue-chip stocks, but can also lead to significant losses if the price continues to drop. It’s crucial to ensure the reason for price drop is temporary or market related and not because the company’s fundamentals have deteriorated.
Importance
Average Down is an important finance term, primarily used in stock trading.
It refers to the practice of purchasing additional shares of a stock at a lower price than the initial investment, which in turn lowers the average cost per share.
This strategy is significant as it allows investors to offset the impact of declines in share prices, turning potential losses into opportunities for profit.
When the stock’s price recovers, investors stand to gain more since the average price of their holdings is lower.
However, this strategy also involves risk as it effectively doubles down on an investment that’s declining in value, hence it’s crucial for investors to be confident about the long-term prospects of the stock.
Explanation
Average down is a financial strategy used by investors when dealing with stocks and shares, especially when the market is volatile. The main purpose of this strategy is to decrease the average cost per share of a stock an investor owns. This happens by buying additional shares at a lower price than the initial purchase price.
Consequently, the average price per share of that stock decreases, hence the term “Average Down.” By averaging down, an investor essentially lowers their break-even point for that investment, which in layman terms is the point at which an investment will generate a return equal to its purchase price. Utilizing the average down strategy can be particularly beneficial during market downturns, when stock prices tend to decrease significantly. When the market rebounds, the investor stands to gain more because of the lower average cost base of their investment.
The primary goal behind this maneuver is to earn more significant profits when the price recovers or to reduce potential losses. However, it’s important to use it judiciously as there’s always a risk the stock’s price might never recover. Averaging down should only be used if the investor strongly believes in the long-term viability of the company and the temporary nature of the price drop.
Examples of Average Down
Average Down is a financial strategy where an investor buys more of a stock as the price decreases, which in turn reduces the average cost per share. Here are three real-world examples of ‘Average Down’:Maria bought 100 shares of XYZ Corp at $50 per share. Later, the XYZ share price dropped to $Seeing potential in the company, Maria decided to buy 100 more shares at the new price of $
In such a scenario, Maria is averaging down. Originally, her average cost per share was $50, but after buying at $40, her average cost per share fell to $An investor holds 50 shares of ABC Company, which he acquired for $20/share, costing him $1,After some time, the stock price fell to $15/share. He decided to average down by purchasing another 50 shares at this lower price point, adding up to a total of $
Now overall, his average cost per share is $50 (($1000+$750)/(50+50)), rather than the initial $John purchased 10 shares of a tech stock at $200 each, spending $2,000 in total. Unfortunately, the stock price fell to $150 in the following weeks. Instead of selling his shares, John decided to average down and bought another 10 shares at the new price. Now, John spent a total of $3,000 for 20 shares, making his average buy-in price $150 per share, thereby reducing his overall cost from $200 per share to $
These examples show how averaging down can be beneficial to investors. However, it must be noted that it is a risky strategy as there is no assurance that the stock price will rebound.
FAQ: Average Down
What does “Average Down” mean in finance?
“Average Down” refers to the practice of buying more of an investment when its price has dropped, resulting in a lower average cost per unit.
Why would one choose to average down?
Investors average down to lower their average cost per unit of an investment, potentially leading to higher relative returns if the price rebounds. However, this strategy can bear risk if the price continues to decline.
Is “Averaging Down” suitable for every investor?
No, it’s not suitable for every investor. Such strategy requires a significant amount of research and understanding of the market sentiment towards the asset. It’s usually more suitable for experienced long-term investors who are convinced of a price rebound.
What is the risk involved in “Averaging Down”?
The main risk is that the price continues to fall after acquiring more shares. If that happens, the losses get amplified. So, it is important to understand that “averaging down” is not a guarantee of profitability.
How does “Averaging Down” effect the portfolio?
Averaging down can potentially increase the profitability of your portfolio if the price of an asset increases after its purchase. However, it also results in a larger proportion of your portfolio being tied to that asset, increasing your exposure to its price movement.
Related Entrepreneurship Terms
- Cost Averaging
- Investment Strategy
- Share Price
- Market Volatility
- Equity Purchase
Sources for More Information
- Investopedia: A trusted and widely-recognized source for finance and investing definitions, Investopedia offers a comprehensive definition and examples of Average Down.
- The Motley Fool: Known for its investment advice, The Motley Fool provides insights about the Average Down strategy from a practical, real-world perspective.
- MarketWatch: Provides business news, analysis, and stock market data where you can find articles and opinions about the use and risk of the Average Down strategy.
- Bloomberg: A prominent platform for financial, business and market news where in-depth pieces about the Average Down strategy can be found alongside global and regional economic trends.
