Averaging down is a strategy that involves
buying more of a security at a lower price than the original purchase
price in an attempt to lower the overall average cost of the
investment. This is typically done when the investor's initial
investment is experiencing a loss and they believe that the security
is undervalued and will eventually rebound.
By adding to the investment at a lower price, the investor can increase their position size while reducing their average cost per share or unit. This can potentially increase the profitability of the investment if the security rises in value over time.
Here is an example. Let's say an investor buys 100 shares of a stock at $50 per share, for a total investment of $5,000. After a few months, the stock price drops to $40 per share, and the investor believes that the stock is undervalued and will eventually rebound. The investor decides to use the averaging down strategy and purchases an additional 100 shares of the same stock at $40 per share, for a total investment of $4,000.
With the additional purchase of 100 shares at $40 per share, the investor's new average cost per share is now $45 per share ($5,000 + $4,000 = $9,000 total investment / 200 shares = $45 per share). This is lower than the initial purchase price of $50 per share, which means that the investor has reduced their overall cost per share.
If the stock eventually reboounds and rises to $50 per share, the investor will have a potential profit of $5 per share ($50 selling price - $45 average cost per share), which translates to a total profit of $1,000 ($5 profit per share x 200 shares). However, if the stock continues to decline in value, the investor's losses will increase with each additional purchase made through averaging down. This is why it's important to carefully consider the risks and benefits of this strategy before deciding to use it.
However, averaging down can also be risky. If the security continues to decline in value, the investor can end up increasing their losses by buying more at lower prices. Additionally, averaging down requires careful consideration of market conditions, the overall investment strategy, and the individual investor's risk tolerance. It is not always a suitable strategy for every investor or every situation.