Stock Trading Tip: Buying when stock prices go down
Beginner Stock Market Investing, Stock Market Investing Strategies
This technique is commonly known as “averaging down” and means buying additional quantities of a stock even if the price goes down significantly from the price at which the stock was originally acquired. The key question to be addressed is that while the average cost of acquisition of the stock comes down, will the returns be commensurate or will you merely end up with a larger share of a loss-making investment.
Investors are divided into two camps on this issue with directly conflicting views. One camp holds that this is a cost-effective way of accumulating profits to while the other camp regards this as a surefire recipe for disaster. Problems of averaging down are often long-term value investors who may also be carrying out a contrarian investment strategy. Contrarians believe in investing against the prevailing market trend. The argument advanced for averaging down is that if you liked a stock at $100, you should love it at $50. Let us say that you have an investment in company A and your research shows that the outlook for the long-term is good. You may well view a decline in the stock price of the company as a buying opportunity and believed that the market is being unduly pessimistic in its valuation. You would justify your decision with the argument that the stock is now at a discount to its intrinsic value.
Short-term investors rarely espouse averaging down because they believe that this is throwing good money after bad. They may view a reduction in the stock price as an indication of a declining trend and will rarely trade against the trend. The indicators that they may normally use such as momentum indicators would not justify a further investment in the stock. Moreover, a short-term investor may have bought company A at $75 with a stop loss of $65. If the price drops to $65, rather than viewing this as a buying opportunity, he would prefer to crystallize his loss and sell the investment.
The main advantage of averaging down is that it can bring down your acquisition cost substantially and therefore reduce your break even price. If the share price rebounds sharply, you may end up making a much larger profit than you had originally envisaged. Let us say that you by 100 shares of company A that $50 per share and buy another 100 shares when the price drops to $40. You have averaged down your acquisition cost to $45 per share. If the share price rises to $48, you are better than break even if your original entry price was $50. At a price of $55, your profit is $2000 against the $500 that you would have earned had you not averaged down.
You will notice that if there is a sharp appreciation in the stock price, your profits will multiply but if the decline continues, your losses will also multiply. Averaging down is thus a double-edged sword and you should do lots of research and analysis before making your decision. Investors like the legendary Warren Buffet have successfully practiced this strategy for years but you should always bear in mind that your pockets are highly unlikely to be as deep as his.
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