Averaging Down - Good Idea Or Foolish Risk?
- By Pauline Go
- Investing
- Unrated
Pauline Go
Pauline Go is an online leading expert in finance industry. She also offers top quality financial tips to investor like:
Refinance Car Loan People with Bad Credit, How To Calculate Credit Score and How To Get Out Of Debt.
Averaging Down - Good Idea Or Foolish Risk?
The term 'averaging down' defines a strategy that involves investing additional amounts in a financial instrument or asset, if it declines significantly in price after the original investment is made. This definitely lowers the average cost in a stock that has dropped in price. However, would the action lead to great returns or just to a larger share of a losing investment is highly debatable.
If the stock rebounds to a higher price per share, then the strategy yields success. But, if the stock continues falling, one needs to decide on either constantly averaging down or bailing out with a loss. Investors and traders opine extremely conflicting view points regarding this strategy. Some perceive averaging down as a cost-effective approach to wealth accumulation; whereas those opposing the view consider it as a step towards disaster.
First, let us look at the advantages of averaging down. The main advantage of averaging down is that an investor can bring down the average cost of a stock holding quite substantially. Assuming that the stock turns around, this ensures a lower break even point for the stock position, resulting in a steep financial gain in comparison to the absence of averaging down.
Investing in a company as opposed to a stock, calls for a deep research on part of the investors. This normally enables the investor to assess the drop in the stock's price as a temporary change or a sign of trouble. Also, this strategy works wonders for long term investors. Such people view a sharp decline in the stock as a buying opportunity and on the contrary believe that others are being unduly pessimistic in context to the long term prospects. For this category of investors, this is the time to accumulate more stock at a lower price.
In the stock market, swimming against the tide can sometimes prove profitable, but at times it can also drown you! Averaging down proves worthwhile when the stock eventually rebounds thereby, magnifying the gains to a large extent. However, if the stock continues to decline, losses are also magnified proportionately. Therefore, it is prudent to correctly assess the risk profile of the stock being averaged down.
Another drawback of averaging down is that it may result in a higher-than-desired weighting of a stock or sector in an investment portfolio. Investors and traders with short term plans, view a stock decline as a warning signal. If one has invested in a stock instead of a company, the basic aim is money trading and no real interest lies in the underlying company. In such circumstances, the best course of action is to cut losses at no more than 7 percent. If the stock drops that much, it is advisable to sell and move on to the next deal.
Weighing the pros and cons of this strategy, makes it mandatory to gauge a few factors before taking the plunge. One should follow the strategy on a few selected stocks, mainly the high-quality stocks, where the risk of corporate bankruptcy is low. It is also pertinent to analyze the fundamentals of the company thoroughly. This aids in ascertaining whether a significant decline in a stock is only a temporary phenomenon or an indication of a deeper malaise. Averaging down can be immensely profitable in situations of unwarranted fear and panic in the markets. Panic liquidation may result in high-quality stocks being available at highly convincing values.
The viability of averaging down depends on the judicious decision of identifying the positions to average down. The strategy is best restricted to blue chips which showcase long-term track record, minimal debt and solid cash flows. Therefore, the best option is to pick up the stocks that are best positioned to survive the shakeout.
If the stock rebounds to a higher price per share, then the strategy yields success. But, if the stock continues falling, one needs to decide on either constantly averaging down or bailing out with a loss. Investors and traders opine extremely conflicting view points regarding this strategy. Some perceive averaging down as a cost-effective approach to wealth accumulation; whereas those opposing the view consider it as a step towards disaster.
First, let us look at the advantages of averaging down. The main advantage of averaging down is that an investor can bring down the average cost of a stock holding quite substantially. Assuming that the stock turns around, this ensures a lower break even point for the stock position, resulting in a steep financial gain in comparison to the absence of averaging down.
Investing in a company as opposed to a stock, calls for a deep research on part of the investors. This normally enables the investor to assess the drop in the stock's price as a temporary change or a sign of trouble. Also, this strategy works wonders for long term investors. Such people view a sharp decline in the stock as a buying opportunity and on the contrary believe that others are being unduly pessimistic in context to the long term prospects. For this category of investors, this is the time to accumulate more stock at a lower price.
In the stock market, swimming against the tide can sometimes prove profitable, but at times it can also drown you! Averaging down proves worthwhile when the stock eventually rebounds thereby, magnifying the gains to a large extent. However, if the stock continues to decline, losses are also magnified proportionately. Therefore, it is prudent to correctly assess the risk profile of the stock being averaged down.
Another drawback of averaging down is that it may result in a higher-than-desired weighting of a stock or sector in an investment portfolio. Investors and traders with short term plans, view a stock decline as a warning signal. If one has invested in a stock instead of a company, the basic aim is money trading and no real interest lies in the underlying company. In such circumstances, the best course of action is to cut losses at no more than 7 percent. If the stock drops that much, it is advisable to sell and move on to the next deal.
Weighing the pros and cons of this strategy, makes it mandatory to gauge a few factors before taking the plunge. One should follow the strategy on a few selected stocks, mainly the high-quality stocks, where the risk of corporate bankruptcy is low. It is also pertinent to analyze the fundamentals of the company thoroughly. This aids in ascertaining whether a significant decline in a stock is only a temporary phenomenon or an indication of a deeper malaise. Averaging down can be immensely profitable in situations of unwarranted fear and panic in the markets. Panic liquidation may result in high-quality stocks being available at highly convincing values.
The viability of averaging down depends on the judicious decision of identifying the positions to average down. The strategy is best restricted to blue chips which showcase long-term track record, minimal debt and solid cash flows. Therefore, the best option is to pick up the stocks that are best positioned to survive the shakeout.
Reader Comments
Disclaimer: The information contained on this website has been provided as a general service. Any references to specific financial, legal, accounting, or taxation issues are done so in the context of general information and should not be relied upon as fact or construed as advice by the us in any of these areas. You should consult a relevant financial, legal, tax or accounting professional to assist in your particular circumstance.
No Comments Found.