Getting Started: What is Averaging Up and Averaging Down

As an investor, you might feel the jitters when the stock exchange opens.

Do you feel nervous when you see the price of your securities fluctuate?

I am sure many of us share similar emotions.

I am often left in a dilemma as to whether to buy more when the price of my investments rise or fall.

Let us look at two approaches you can consider when making your investment decisions.

Averaging up

This strategy involves purchasing more shares of a stock you already own, but at a higher price than what you originally bought at.

For example, let’s say you purchase 100 shares of company A at S$25 per share, spending a total of S$2,500.

The stock rises to S$30 the next day.

You decide to buy another 100 shares as you feel confident about the prospects of the business.

As the shares are now priced more expensively than before, you end up paying S$3,000.

After this purchase, you will end up with 200 shares at an average share price of S$27.50 [(S$2,500 + S$3,000) divided by 200 shares].

The stock price moves again to S$35 per share the following day.

Again, you add another 100 shares to your portfolio forking out S$3,500.

Now, you own 300 shares with an average purchase price of S$30.

Since your average purchase price increases over time, this process is known as “averaging up”.

Pros

The process of averaging up means you are buying at higher prices due to confidence in the company’s business prospects.

There may be reasons why the stock price has been climbing.

Investors may feel bullish about the business’ potential growth.

These beliefs may be due to catalysts or trends that are driving increases in revenue and profits.

If you invest in a business that is likely to do well, you’ll benefit from capital gains as the share price increases in tandem with the growth in earnings and dividends.

Let’s use an example to illustrate this.

Apple Inc (NASDAQ: APPL) share price was US$6.86 way back in 2010.

Fast forward to today and the company’s share price last closed at US$127.53.

The reason for this?

Apple’s revenue and net profit stood at US$65.2 billion and US$14 billion respectively, back in 2010.

10 years later, the smartphone giant’s revenue and net profit stood at US$274.5 billion and US$57.4 billion.

Revenue was up 321% while net profit surged by 310%.

If you had held on to your shares, you would have multiplied your money by more than 18 times.

And if you had consistently averaged up on Apple’s shares, your wealth would have grown along with it.

Cons

While averaging up can provide great long-term returns due to the growth of the underlying companies, there are risks involved as well.

Unforeseen events may crop up that might adversely impact the business.

If you were averaging up consistently on a business that either fails to grow as expected, or even starts declining, then you may end up paying too much for your share purchases.

Averaging down

Averaging down is the exact opposite of averaging up.

It involves the purchase of additional shares at lower prices.

To illustrate this, let’s use the previous example where you purchase 100 shares of company A at S$25 per share.

The next day, the stock price tumbles to S$20 per share.

You decide to purchase 100 shares at that price, forking out S$2,000.

The following day, the stock price fell again to S$15 per share.

You purchase 100 more shares in the belief that you’re enjoying an even better bargain compared to when the share price was at S$25..

With this third purchase, the shares now cost just S$1,500.

In total, you have used up S$6,000 to buy the 300 shares, dropping your average purchase price down to S$20 from the original S$25.

The above is a simple illustration of how to average down. The graphic also explains this clearly

Pros

Investors who employ this strategy often believe that a lower share price implies an even better bargain, all things being equal.

This method is useful for lowering your average cost and increasing your margin of safety.

Short-term events such as a missed quarterly earnings or temporary obstacle could have caused the share price to fall sharply.

It’s important, however, to ensure that the long-term prognosis for the business remains healthy.

Warren Buffet once said, “Be greedy when others are fearful”.

By scooping up shares on the cheap, you are taking advantage of others’ fear to profitably increase your shareholdings at cheaper prices.

Cons

However, this strategy is only effective if business prospects remain intact.

If the chosen company is a lemon, then declining revenue and profits will almost always lead to further price falls.

It’s a bad idea to average down on a company that faces a bleak future.

In such cases, it is better to exit the investment and move on to a more promising candidate.

Get Smart : Your decision should depend on the business

Ultimately, the health of the business is what drives its stock price.

As a Smart Investor, you should not be alarmed when the stock price falls.

Sentiment and short-term events may have a part to play.

Such volatility is much more common than you’d expect.

If the decline can be explained by a short-term, temporary event, then averaging down may put you ahead of other fearful investors.

Averaging up is a good strategy to use if the business continues to grow by leaps and bounds.

You will benefit from the long-term growth of a strong company by buying additional shares along the way.

However, you should be watchful of risks, monitor corporate developments and continually tweak your investment strategy.

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Disclaimer: Jia Yi owns shares of Apple Inc.

The post Getting Started: What is Averaging Up and Averaging Down appeared first on The Smart Investor.