When to Apply Averaging Down
If the price of your stock has decreased, then a good strategy to lower your average cost may be to apply averaging down.
Some experts consider that this strategy represents the throwing of good money after bad money. However, this claim is somehow controversial since it depends on different factors.
For example you have purchased shares at a particular price. However, the price decreases and in order to average the cost you purchase additional shares at the lower price. This is how averaging down works.
If the price of the stock increases sufficiently after the fall, then averaging down will provide you with great profits. On the other hand the price of the stock may take a reverse direction and continue to fall. In such a case you may continue to average down or sell the stock and suffer the losses.
In order to determine the goodness of this investment strategy you should be able to make a distinction between investing in a stock and investing in a company.
Stock Investing vs. Company Investing
If you are investing in a stock all you are interested in making a profit. You are not interested in the underlying company. The company interests you as far as how the market or different economic news can affect its performance and eventually the price of the stock.
As a result of the lack of knowledge about the company a decline in the price is difficult to be identified as a temporary occurrence or a problem that is about to be reflected in long-term problems. If this is the case, it is good to determine a limit which if reached will trigger the selling of the stock.
On the other hand, company investing includes thorough knowledge of company's fundamentals and activities. You gain knowledge on the activities within the company and the sector in which it operates. Thus, this knowledge provides you with understanding on the effect of a price drop and its meaning.
The company knowledge makes averaging down a viable strategy. When the prices start to decline and you know that there are no problems with the company's fundamentals, then averaging down will provide you with the possibility of purchasing more of the company's stock at lower prices.
This stock accumulation at lower prices makes even more sense if you decide to hold the stock over longer periods of time.
You should examine the trading activity of mutual funds and institutional investors and if they heavily sell the company's stock even though you consider it worth holding, you should probably reconsider your strategy.
Finally, if you are a day trader, averaging down will not be a recommended strategy. If the price of the stock starts to fall it will be better to sell the stock immediately and move to the next investment candidate.
However, averaging down is highly recommended if you practice company investing, since you will be able to accumulate more stocks at lower prices.
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