What’s wrong with averaging down as an investment strategy?

Before you make an investment decision, you have to weigh two things: the appeal of the investment, and the impact that buying it will have on the quality, balance and diversification of your portfolio.While dollar-cost averaging can be a useful strategy, it shouldn’t be confused with averaging down stocks.

“Averaging down stocks”—buying more of a stock you own that has fallen in price, mostly to cut your average cost per share—is a bad way to pick stocks for your portfolio. When you average down, you base investment decisions mostly on a single random factor: a drop in the price of the stock. This can be a minor plus or a major error.

In the case of aggressive stocks, averaging down can be one of the most expensive mistakes you make. That’s because aggressive stocks are more likely to harbour major hidden risks.

Before buying more of a stock that has dropped significantly, you should check for changes in our advice. If we continue to recommend the stock as a buy, that means we think it will turn out okay. But as you probably know, we don’t claim to get it right every time. Nor do we try to predict short-term market trends.

Remember, you need to diversify to succeed as an investor, and you should avoid the mistake of overindulging in any one stock, regardless of how certain you are about its future. While dollar-cost averaging can be an effective long-term strategy, we rarely advise buying more of a stock if it already makes up much more than 5% of your portfolio.

Let’s put it this way: It only pays to average down when it’s a coincidence, not a strategy. It makes sense to buy more of a stock because it’s attractive, not simply because you want to cut your average per-share cost.

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Understand these three reasons why averaging down stocks could work against you

Here are three problems that crop up with averaging down stocks:

1. Averaging down stocks ignores investment quality. Many investors have made lots of money by “averaging in” to the stock of a well-established, well-managed company — that is, buying more as funds became available over a period of years. “Averaging down” is not the same thing. When you systematically average down, you are zeroing in on your losers and running the risk of hurting your stock market returns. It’s true that good stocks can drop and stay down for lengthy periods. But bad stocks are more likely to go down and stay down. If you routinely buy more of any stock you own that goes down, you run the risk of loading up on your worst choices. That costs you money. It will also depress your stock market returns because it keeps you from buying good stocks, due to the fact that your available funds are tied up in bad ones.
2. Hidden problems can cause a stock to fall—and keep falling. Some investors go through a phase when they buy more of anything they own whenever it goes down. It’s as though they want to validate the decision they made to buy it in the first place. Stocks sometimes go down due to random fluctuations and misinformed selling. But they also fall due to festering problems that the public does not yet know about or appreciate.
3. Averaging down can spell disaster with aggressive stocks. Hidden risks are more likely to lurk in aggressive investments. Even with conservative stocks, averaging down is risky. Good stocks do go bad. Stocks that are generally considered conservative sometimes turn out to be anything but.

Practice “averaging in” instead of “averaging down” for better results

Averaging in, similar to Dollar-Cost Averaging, is much more likely to make money for you. This is the practice of adding a fixed or rising sum of money to your portfolio on a fixed schedule every year, regardless of your view of the stock-market outlook.

When you make a habit of averaging in over a period of years if not decades, you are betting that the stock market will go through fluctuations, but will continue to rise over a lengthy period. That’s the smart way to bet, because the market does indeed tend to go up over long periods.

Habitual averaging-in also makes investing simpler. You no longer need to have an opinion on the short-term outlook for the market.

Avoid averaging down stocks, and use our three-part Successful Investor approach instead

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

In summary, with this article, we explore the crucial distinction between averaging down stocks and more effective investment strategies like dollar-cost averaging. While averaging down—buying more shares of a declining stock to lower average cost—might seem intuitive, it often leads to poor investment decisions based solely on price decreases rather than fundamental value. We outline three major risks: ignoring investment quality, overlooking hidden problems that cause price drops, and increased exposure to aggressive stocks’ inherent risks. Instead, we encourage you to practice “averaging in” by consistently investing fixed amounts over time, regardless of market conditions. This approach, combined with proper diversification across economic sectors and focus on high-quality, dividend-paying stocks, provides a more robust investment strategy. The key takeaway is that investment decisions should be based on thorough analysis of a stock’s intrinsic value and its fit within a diversified portfolio, rather than attempting to average down costs of declining investments.

Some investors believe averaging down is a good idea when the market is down. Do you agree with this notion?

Have you been tempted to use an averaging down strategy? What decision did you make?

This article was originally published in January 2022 and is regularly updated.