“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 lowers your average cost per share, but can cost you money in the long run. At the same time, you run the risk of distorting your overall portfolio management strategy.

Portfolio management: 3 reasons to avoid “averaging down.”

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 different. 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 and lowers your stock market returns because it keeps you from buying good stocks, since your 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 their decision 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.

Quality and diversification are key to successful portfolio management

Before you buy more of any stock that has dropped significantly, we recommend that you consult our investment newsletters (including our flagship publication, The Successful Investor) 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 portfolio management strategy. What impact will it have on your portfolio? If buying more would put the stock above, say, 5% of your overall portfolio, we would often advise against it.

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

Let’s put it this way: The only time it pays to average down is when it’s a coincidence. You want to buy more of a stock because it’s attractive, not because you bought it at higher prices.

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