Why You Should Average Down On Existing Positions

Following is a guest post from Dividend Beginner

Hello R2R readers, I am The Dividend Beginner, a 22-year old Canadian dividend growth investor from Montreal. I started following other DGI bloggers after I made my first stock purchase in the Vanguard US Total Stock Market Index ETF (TSE: VUN). Once I realized the benefits of dividend growth investing from an assortment of blogs, Roadmap2Retire being one of my favourites, I decided I too would become a dividend growth investor, with a focus on Canadian stocks. I sold my shares in VUN shortly after and began my DGI journey. In less than a year I’ve built up a passive income stream consisting of an average dividend income of $100 per month. I plan to be financially independent in my 30’s, though I don’t have it all planned out in full detail now. By day I’m a full-time medical software developer, and in my free time I enjoy reading about finance, the economy, and stocks, investing in dividend growth stocks, and developing apps and websites. You can view all my writing on The Dividend Beginner blog (www.dividendbeginner.com), and engage with me on twitter, @dividendbegin.

What is “Averaging Down”?

The process of averaging down on your stock investments is a technique wherein you purchase more shares of a currently held stock at lower prices than which you originally purchased. Through this process, you bring down the per share cost basis of your investment in that company; this makes it easier to break even or to turn a profit, but also makes it easier to lose more money as you’ve built a larger concentration of shares.

The Case For Averaging Down

Considering recent market conditions, as we come closer and closer to a full-fledged bear market, the over all cost of stocks fall as a whole, regardless of whether a company’s fundamentals remain completely unchanged or not; realize that many investors are afraid and sell off their shares to either realize a profit from having held shares for so long, or to eliminate the possibility of losing more money.

This makes it easier for other investors who are in the accumulation stage to swoop in and pick up shares at a discount.

The following points illustrate why it’s a good idea to average down on stocks in this current market condition, and takes into account this fact: You are a long-term investor, not a short-term trader.

You are considering averaging down on an investment which fits these qualifications: the company has paid dividends for over a decade, and hopefully has raised them consistently (throughout 2008 -2009), a solid balance sheet, low P/E ratios, low debt levels, and reasonable (for the particular industry) payout ratios.

  1. You will lower your average per-share purchase price. Say you purchase 100 shares of stock X at $10 per share ($1000 for 100 shares). The company’s stock price then falls 10% to $9. You pick up another 100 shares (now $900). You now own 200 shares, with an average per-share purchase price of $9.50.
  2. You will need a smaller return on your investment to break-even or turn a profit. Continuing with the situation from Point #2, the stock price now only needs to rise to $9.50 (5.56%) for you to break even on your investment. If you did not average down, the stock price would need to rise to $10.00 (11.11%) to break even on your investment.
  3. You will increase your yield-on-cost. Continuing with the previous example, let’s say stock X pays an annual dividend of $1.00. Originally, your investment nets you a yield-on-cost of 10%. Once you double your position at $9 a share (which holds a yield of 11.11%), your yield-on-cost will increase from 10% to 10.55%. You are now receiving 0.55% more  in dividends on each of these shares which you averaged down with.
  4. You will lower your total loss as a percentage. After your 100 shares of Stock X has fallen 10% from $10.00 to $9.00 a share, your total loss on capital is 10.00% (a loss of $100.00 on a cost basis of $1000.00 represents a 10.00% loss). Once you average down by doubling your position in company X, your total loss on capital is now 5.26% (a loss of $100.00 on a cost basis of $1900.00 represents a 5.26% loss).

The Case Against Averaging Down

While averaging down reduces your per-share cost basis, it also increases your concentration to a company which is experiencing a share price reduction. By doing so, this also makes it easier for you to lose more money than you originally would have. This is not likely to be an issue if you had been a thoughtful investor and did your due diligence in analyzing companies closely before allocating capital. An investor in their accumulation phase should be ecstatic (I know I have been) when they see the share prices of companies which are attractive to them dropping, as they can add more to their portfolio at even more attractive prices.

  1. If the stock price continues to fall, the investor’s losses will be greater since he owns more shares. Let’s say stock X falls another 10% after doubling down and increasing your concentration to 200 shares. This will result in another loss of $180 based on the current market value of $1800.00. After having doubled down, your total loss amounts to -$280.00. If you had not doubled down, the extra 10% drop would have resulted in a loss of $90.00 based on the market value of $900.00 after the initial 10% drop. This means if you had not averaged down, your total loss would be -$190.00 rather than -$280.00.
  2. By pumping more money into a stock which continues to drop, your money is concentrated in a weak stock which could be better utilized in a company with an increasing share price. While Stock X fell 10% and then another 10%, Stock Y rose 10%, but your capital was all concentrated into Stock X. The thing about this point, however, is that no one has any clue which stocks will go down or up, not even the professionals who earn salaries above $100, 000.

How Should You Average Down?

Averaging down can be both rewarding and dangerous, as is the case for just about any technique or product revolving around the stock market. Before averaging down on any investment, it’s highly recommended that an investor have a plan, rather than throwing money ad hoc into a company with a falling share price.

An investor must know exactly what he is doing when he is averaging down on an investment. For example, personally I would not average down on an investment unless I was 10% or more below my purchase price. This way I create a larger spread and there is meaning to averaging down, rather than just buying more shares at roughly the same price. If the position was not a full position at that point in my portfolio, I may add a third time once the purchase price falls around 15% or more again. Another thing I plan on doing due to current market conditions is entering into new positions or adding to existing positions a little more conservatively, as the overall market appears to be falling. After opening a position and adding to it three times, I consider myself to own a full position in that company, as I add around $1, 200 to $2, 000 per transaction. I try not to have any single holding account for more than 15% of my portfolio, and preferably no more than 10% – diversification is a very important concept.

While averaging down on these important portfolio positions, I reduce my average per share purchase price,  I lower my total loss as a percentage and make it easier to break-even, and increase my yield-on-cost. There are a good list of reasons why averaging down on existing positions is a great idea when they’re companies you plan on holding long-term and believe in them. However, make sure you perform due diligence on the companies you wish to average down on, rather than throwing cash into a declining investment.

What are your thoughts on averaging down? Do you follow this technique often? Has it proven useful to you? Do you prefer not to? 

11 thoughts on “Why You Should Average Down On Existing Positions

  1. I’ve been doing some averaging down. It’s particularly helpful, because if the stock is down 10%, it need to rise 12.5% to be back to the same level, if you buy a different stock that was also down by 10%, even when the stock rise 10%, you’d still be in red.

    That’s why I only been investing 10 shares at a time, if the stock rises, I leave My investment the same, if the stocks decrease, I’d average down.

    We all know millionaires are made during stock correction or in the bear market, because we can all buy at low prices. It might look bad, shortterm, but in long term, it will pay off.

    If we fall into recession for another 3-5 years, I might not leave my job, if I stay in the workforce during the bear market, my retirement income would should up 50-100% more with just a few more years. I’ll invest 100% of my extra earning into the stock market.

    I think many of the millennials have also learned the lesson, and probably have the same mentality. Even the finanal guru like gocurrycracker are wishing for another 25% correction because they want to unload the rest of their cash to up their income.

    • Hi Vivianne,

      You’re spot on in everything you said. Indeed it does take quite a bit more for share price to increase before you can break even, which is not the same percentage as your loss.

      I do the same by averaging down on the stocks which are going down, and leave the ones which are appreciating to their own business.

      If you have the ability to stay in work longer to increase your dividend income, if the next couple years prove to be a full-fledged bear market, you’d indeed be able to increase your dividend income greatly!

      I’m wishing for a correction over here too, nothing like getting good stocks on sale while the fickle investors dump them.

      Best regards,

  2. Averaging down is a great technique, in general, and it has produced worthwhile results over these last 7 years or so…

    With that said, I think it’s also extremely important to pay attention to macro events because if sentiment changes, it tends to do so on a dime. This bull run is very long in the tooth and the natural forces of deflation are starting to win over…

    I’ve been loading up on commodities, and my own rule-of-thumb is to average down aggressively when any position is down 20%+… For blue chip dividend stocks, 15% might be more reasonable as those stocks are far less volatile…

    In any case, given current market dynamics, I would focus much more on defense than trying to squeeze out any minuscule gains that might be left (any “bargains” available today aren’t going to produce any life-changing gains)… I don’t see anything wrong with continuing to buy and DCA into positions, but you MUST have cash available at all times, especially in a deflation.

    We have not seen a bear market since 2009… but fortunes are made when you can buy at the bottom and have funds readily available.

    2016 is gonna be a bumpy year… Patience will be rewarded. As I like to say, we haven’t seen anything yet… These last two weeks are the conclusion of pregame warmups, at best…

    • Hey FIF,

      Indeed macro events are something that need to be looked at as well at the time you’re deciding to average down, personally I’m not averaging down on my oil-based stocks right now, until things start to settle a bit more. They just keep doing down, down, down. It’s a falling knife I’m not fond of catching at this moment.

      15% – 20% is a great time to average down on your stocks, so kudos for having your own numbers there. It’s definitely safer to be averaging down on blue-chips; it’s what I feel most comfortable doing.

      I agree with you completely about focusing on defense.. I’d like to invest in some sectors which show lower volatility, like consumer staples. Generally from what I’ve seen on the Canadian side, they tend to be more expensive (P/E-wise), but sometimes you just have to bite the bullet.

      2016 will be a bumpy year, and if the past two weeks have been nothing but a warm-up, I’m ready for the big drop, got cash on the side, and am excited to be purchasing stocks at cheaper prices and higher yields.

      Best regards,

  3. It is on my mind as well to use some of my cash to buy more of my trackers. I just do not plan to put in all my money right now. It is similar to your 2 or 3 step approach.

    I am thinking to do an additional buy this week for my world tracker. And then wait a little longer to see how it goes.

    We have some more cash coming in early feb from the taxes. That would be another good cash pile to average down on my trackers.

    I have no crystal ball, but there might be more opportunities this year I believe.

    • Hey AT,

      It’s a good idea to separate your stock purchases over a percentage drop AND a time, like you’re explaining. That’s what I tend to do as well. In most cases it doesn’t make a whole lot of sense to buy every single time your shares drop below a percentage threshold if you just reinvested into the company or a similar one.

      Keeping cash on the side is a good idea, as it looks like things will continue to drop throughout the year as far as I can see. Good times.

      Best regards,

  4. I think in general averaging down on solid stocks is a great idea. However when the company is suffering and the future outlook is bleak, then average down may not make much sense. Agree with FI Fighter that 2016 is going to be a bumpy year.

    • Hey Tawcan,

      The plan is to average down on solid blue-chip companies, where you are quite certain that the share price will bounce back after tough times have been over, and that the company can survive tough times.

      If the future outlook of a company is bleak, and the share price continues to drop – as hard as it is, the best option is to usually drop the investment and allocate your capital where it can be better utilized. Sometimes, this is really hard to take though.

      Looking forward to a year of sales!

      Best regards,

  5. Not much for me to say, other than I’m glad to see you starting your dividend journey so early in life. If you stay consistent, you will achieve financial freedom in your thirties.

    As for averaging down, you certainly don’t have to convince me.

    ARB–Angry Retail Banker

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