A bargain is generally regarded as a good thing. What could be a better bargain for investors than buying shares of a stock at lower prices?

“Averaging down” is the well-known market tactic by which investors buy more shares of a stock that has come down in price.

Averaging down does lower your average cost per share, but the fact is that it can cost you money in the long run. At the same time, you run the risk of distorting your overall portfolio management strategy.

3 reasons why “averaging down” could work against you

Here are three problems that crop up with averaging down:

1. Averaging down 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.

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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.

Before you buy more of any stock that has dropped significantly, we recommend that you consult our investment newsletters for changes in our buy/sell/hold advice. If we continue to recommend the stock as a buy, that means we think the stock will be okay at the very least, and perhaps much better. But keep in mind that no one can predict such things with 100% certainty.

Moreover, you should consider any purchase in light of your overall portfolio. What impact will it have on the whole? If buying more would put the stock above, say, 5% of your overall portfolio, we would frequently advise against it.

The key to good portfolio management is to avoid investing too heavily in any one stock, no matter how optimistic you are about its future.

Our investment advice: It only pays to average down when the fall in the share price is a coincidence, and you just happen to get the stock you like at a lower price. You want to buy more of a stock because it continues to be an attractive company, not because you bought it at higher prices.

COMMENTS PLEASE:

An old saying has it that “You get what you pay for.” The idea applies to averaging down in many cases. It also says something about stocks with suspiciously low p/e ratios or high dividend yields. Can you describe a time when understanding the idea helped your investing? Or did a failure to understand it cost you money? Let us know what you think in the comments section below. Click here.