Averaging in the stock market is when investors gradually increase the number of shares they have over time, in their best stocks. However, averaging up and averaging down are two different types of averaging in the stock market, and one is more controversial than the other.
Averaging Up in the Stock Market
Buying more of your best stocks, also called averaging up or pyramiding, is something most great investors through the years have practiced. However, like any tool, it can also be dangerous if misused.
The most important key is to buy smaller and smaller amounts on the way up—hence the term pyramiding, which obviously starts out with a wide bottom (your initial purchase) and gets narrower and narrower toward the top (your follow-up buys). Averaging up in this fashion ensures that your average cost doesn’t run up too fast, yet allows you to funnel more money into a potential big winner.
Some investors prefer to average up any time the stock rises a certain amount from their previous purchase price, while others like to wait for specific chart set-ups. There is no one right way to do it, just be sure that whatever strategy you employ, it works for you—you’ll be heavily invested in some stocks using this method, which means the upside and downside will be sharper.
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Here are a few more tips on averaging up, from our small-cap investing expert Tyler Laundon:
Average out your cost basis: It’s wise to average into a new position. For example, one might buy an initial position of 50 shares of a certain stock at $40.00 per share today, for a total investment of $2,000. Several weeks later they make a second purchase of 55 shares at $36.39 for approximately $2,000. The two purchases represent a total investment of $4,000 for 105 shares, at an average cost of $38.10. The strategy helps to reduce the risk of buying a full position in a stock at a poor time (it happens).
Take partial profits: If averaging into a position seems to make sense to you then the opposite should as well. I’ll typically recommend that investors sell up to half of their position once we have a capital gain of 30% to 60%. This strategy helps to avoid the heartache of having a nice profit evaporate due to some unforeseen negative event.
Allocate more funds to your strongest stocks: There’s nothing wrong with buying more of a stock that is going up. Averaging up doesn’t mean always waiting for a stock you own to fall. Stocks are often momentum vehicles – they tend to continue on their general trajectory (both higher, and lower) for longer than investors expect. One of the best ways to increase your profit potential is to simply buy more of what’s working.
That said, there is no one right way to do it when averaging up. Just be sure that whatever strategy you employ, it works for you—you’ll be heavily invested in some stocks using this method, which means the upside and downside will be sharper.
Averaging Down in the Stock Market
Averaging in the stock market isn’t limited to averaging up, in fact, many investors average down.
For a growth investor, the number one, never-break rule is to cut all losses short. Instead, some investors love to average down, buying more of their losers to lower their average cost.
Averaging down, although controversial, is another strategy investors implement when trying to maximize returns. The strategy consists of investors purchasing additional shares of a stock they own when that stock experiences a sharp decrease. Investors see this as an affordable way to increase their returns.
Investors in favor of averaging down basically view it as buying stocks at a discount. Since these are long-term investors, they realize the stock could continue to decrease. However, they also understand that when the trend curves upward, they could be looking at some pretty hefty profits.
However, many investors believe this to be a foolish strategy. They see this as the beginning of continual declines and are concerned about when the stock will increase again and by how much.
In the book, How to Trade in Stocks, Jesse Livermore gave a great example of a stock trader buying more shares every three points on the way down, detailing how the averaging-down investor thinks. After describing buying more and more from 50 down to 29, the last line was prescient: “Of course abnormal moves such as the one indicated do not happen often. But it is just such abnormal moves against which the speculator must guard to avoid disaster.”
In other words, averaging down here and there might allow you to “get out even,” but it takes just one severe break in a stock in which you’ve been averaging down to put your portfolio behind the 8 ball.
Significant risk does accompany averaging down when averaging in the stock market, however, if properly done, averaging down has the potential to produce big returns. But before deciding to follow this strategy, investors should do their research and determine if their stock is projected to increase after the downtrends.
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*This post is periodically updated to reflect market conditions.