Whenever some financial “pundit” says that the best way to get into a stock is by averaging down, we sometimes cringe. Why? Because, at best, you’ll be getting into a stock at a lower average price…but more importantly, you can be getting into a stock that’s poised to sink much, much lower and that’s a risk no one wants to take.
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What is “averaging down”?
The concept of “averaging down” is straightforward. Say you buy a hundred shares of a stock at $100. It goes down to $90 and you buy more a hundred more. Your average cost per share has now been lowered to $95. Repeating this action as the stock falls will lower your average cost per share even more. Sounds good, right?
Investing or trading?
It depends. If you’re investing in the stock, that is, you’re viewing this as a trade and not a long-term investment then averaging down is a strategy that runs counter to your goal of making a profit. Traders use buy and sell indicators to determine when to enter and exit positions. Should a stock fall enough to trigger a stop-loss, they exit the position and take a small loss at the most. Stock traders either don’t care or don’t know enough about the company’s fundamentals to determine whether or not the drop in price is due to a temporary lack of buyers or whether it’s reflecting a more serious problem that they don’t know about or hasn’t yet surfaced.
The situation may be different, though, if you’re investing in the company itself. If, after doing your homework, you are convinced that the company is a good value and you are planning on holding the stock for a long time, then averaging down may work to your advantage. The operative word here is “may.”
Even if you’re convinced that management is on the right track and the fundamentals are solid, I still have a bias against this approach for a couple of good reasons.
- One is the fact that hype and circumstances can blind even the most judicious, rational investor…Remember the dot-com bubble in 2000 when Internet stocks were bid up to frighteningly high valuations? How many of them are in business now? Go.com and Pets.com were two Internet darlings that quickly flamed out once the bubble burst.
- Or what about accounting scandals that were kept so hush-hush that even top Wall Street analysts were fooled? Think Enron, Tyco, and WorldCom-companies that wiped out many a retirement account.
If you can’t rely on market hype or trust fundamentals, then what recourse do you have other than using your mattress as a retirement plan? The answer is to follow the technicals because, unlike people, numbers don’t lie…