Averaging Down: Good Idea Or Big Mistake?

The strategy of "averaging down", as the term implies, involves investing additional amounts in a financial instrument or asset if it declines significantly in price after the original investment is made. It's true that this action brings down the average cost of the instrument or asset, but will it lead to great returns or just to a larger share of a losing investment?

Practical Applications

Some of the world's most astute investors, including Warren Buffett, have successfully used the averaging down strategy over the years. While the pockets of the average investor are nowhere near as deep as deep as Buffett's, averaging down can still be a viable strategy, albeit with a few caveats:

Averaging down should be done on a selective basis for specific stocks, rather than as a catch-all strategy for every stock in a portfolio. This strategy is best restricted to high-quality, blue-chip stocks where the risk of corporate bankruptcy is low. Blue chips that satisfy stringent criteria - which include a long-term track record, strong competitive position, very low or no debt, stable business, solid cash flows, and sound management - may be suitable candidates for averaging down.

Before averaging down a position, the company's fundamentals should be thoroughly assessed. The investor should ascertain whether a significant decline in a stock is only a temporary phenomenon, or a symptom of a deeper malaise. At a minimum, factors that need to be assessed are the company's competitive position, long-term earnings outlook, business stability and capital structure.

The strategy may be particularly suited to times when there is an inordinate amount of fear and panic in the markets, because panic liquidation may result in high-quality stocks being available at compelling valuations. For example, some of the biggest technology stocks were trading at bargain-basement levels in the summer of 2002, while U.S. and international bank stocks were on sale in the second half of 2008. The key, of course, is exercising prudent judgment in picking the stocks that are best positioned to survive the shakeout.

http://www.investopedia.com/articles/stocks/08/average-down-dollar-cost-average.asp?partner=NTU

Comment:

In a poker game, when would you put more money onto the table? Putting money on the table may results in a bigger loss or a bigger gain. Averaging down in buying stocks shares similar conotations. However, there are situations as listed above, when averaging down may be a strategy you can employ selectively.