If you talk to almost any investor who has been investing for a while, they will likely tell you that averaging down on shares is a dangerous game and it’s something you probably shouldn’t do unless you are sure you know what you are doing.
What is Averaging Down
I’ll quickly give an example of averaging down so that you know what I am talking about.
Let’s say I buy 10,000 shares at $1. My total cost is $10,000.
Then the stock price takes a dive and now sites at 70 cents. The value of the 10,000 shares I hold is now only $7,000 – I have made a loss of $3,000.
However, I could then average down my total cost for this stock.
If I bought another 10,000 shares at 70 cents that would cost me an additional $7,000. The total value of my holding would now be $14,000 (i’m still down $3,000 overall), but my average share purchase price (for all my shares) is now 85cents.
- 10,000 shares @ $1 = $10,000
- 10,000 shares @ $0.70 = $7,000
- Total shares: 20,000
- Total cost: $17,000
- Average Price: $0.85
By averaging down, I now only need the share price to go above 85 cents for me to make a overall profit on this stock. If I never bought the extra shares at 70 cents I would need to wait for it to go back above $1.
Why is Averaging Down Dangerous?
The main reason averaging down is so dangerous is because you have to pump more money into a stock that you are already losing money on. Some may consider this throwing away good money after bad, and in some cases they are likely right.
The risk is that the company might go broke, or there is something going on with the stock that you aren’t aware of, which may be impacting the share price.
It’s not for the feint of heart, and I certainly don’t recommend anyone do this.
Why do I do it?
The main reason I do it is because I am using money I don’t mind losing, plus, I have yet to lose using this strategy. I know that it is only a matter of time, but so far I have successfully averaged down on at least 10 stocks over the last 7 or 8 years. Plus, I don’t do this with stocks I am trading, only stocks that I am investing in for the longer term.
My reasoning is this – If I bought into a stock at $1 because it was a good deal, then provided the fundamentals for the company haven’t changed, then the stock at a lower price must be an even better deal.
One of the best examples I have of this working for me, was a little stock called Eden Energy. Every couple of weeks the stock price kept going down and down, so I ended up averaging down on it a few times. The reason I didn’t cut my losses was that I knew that they were releasing something pretty big early in the new year, so I would simply wait for that news and sell out them.
After only a few months I was back in profit, and then I ended up selling the entire lot at $0.16 for about $23,000 ($14,000 profit – less tax) in under a year. I actually could have sold for $0.185, but unfortunately I missed that opportunity because I got greedy.
Why Am I Telling You About this?
I appreciate that it may seem a little odd that I tell you about an investment strategy that I employ, that makes me money, but then I tell you not to use it. The reason is that it really is a risky strategy, and here in Australia the tax laws almost encourage people to take big risks like this (if I lose money on a stock, the government allows me to deduct that against gains that I have made on other stocks – so I can only ever lose if I never make a profit. Plus, I can carry any losses forward over future tax years).
So I hope you understand why I don’t ever encourage people to invest like this, unless you have really thought it through, and you are prepared to accept the risks.