An old adage in the stock market says to "buy low and sell high." But what if you pay a high price for a stock to begin with? Averaging down is a way that you can lower the cost basis of your stock and improve your chances of selling high in the future, assuming the stock ultimately goes up in value. The strategy does carry risks, however, and doesn't guarantee a profit in a stock.
Cost basis is how much you pay for a stock, including any fees or commissions. For example, if you buy 100 shares of stock at $24.95 per share and pay a $5 commission, your cost basis for that purchase is $2,500. Your net average cost per share is therefore $25. You'll need to know your cost basis to determine when you will turn a profit on a stock position. You'll also need it to report to the IRS when you file your taxes after you sell the stock.
You can average down the price of your stock if you buy more shares when the price has fallen. Let's stick with your original 100 shares of stock with a cost basis of $2,500. If you then bought an additional 100 shares of stock at $9.95 per share plus a $5 commission, your total cost for all your shares would be $2,500 plus $1,000, or $3,500. Divide that amount by the 200 shares you now own and your average cost per share drops to $17.50, down from the original $25.
Benefits of Averaging Down
The most obvious benefit of averaging down is that if the stock price turns back up, it doesn't have to go as far for you to turn a profit. By purchasing two separate lots at $24.95 and $9.95 respectively, you can now turn a profit if the stock climbs back above $17.50. Even if the stock never makes it back to your original purchase price of $24.95, you can make money if you sell your whole position at $20, for example.
Risks of Averaging Down
Sometimes, a falling stock price means that a company is in trouble. If a stock price is down for company-specific reasons rather than just following the trend of the overall market, averaging down may only compound your problem. Averaging down on a losing stock essentially amounts to doubling down on a bad bet. Unless the company has a turnaround in its future, you could end up losing more than your original investment.
- While averaging down can be a successful strategy if a stock rebounds, you could lose twice as much money if the stock never turns around. Many advisers caution against averaging down unless prospects for a stock rebound are high, and the reason for the original decline was irrational.