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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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?