Averaging down is a move that has been covered with so much controversy within the investment arena. Although it’s largely regarded as a brilliant step to reduce the buying cost in falling markets, it also involves dangers that can result in huge losses if not well planned. We at VSRK Capital know that investing is not all about being trendy but making a choice based on your risk tolerance, goals, and the prevailing market situation. We will discuss if averaging down is a sound investment strategy or a risk and when to apply this strategy.
What Is Averaging Down?
Averaging down is a strategy where you purchase additional shares of an asset or stock that declined in value, thus reducing your average cost per share. You are expecting the asset to regain its value in the future so you can take advantage of the price appreciation. For instance, if you purchased 100 shares at ₹100 each and the price falls to ₹80, purchasing additional shares at ₹80 lowers your average cost. The approach is dangerous, though, if the asset continues to fall.
When to Average Down?
Averaging down can be a smart strategy in some situations, but only if it is done with an eye towards the long-term potential of the asset. The following are some things to consider when deciding whether to average down:
The Long-Term Potential of the Asset
If the underlying of the asset is sound and you feel that the price decline is only temporary, averaging down can be an acceptable move. For example, if the earnings of a company are still increasing, the company has a solid business model, and the price decline is only temporary, averaging down can be used as a strategy to consolidate your position at a lower cost.
Risk Tolerance
Investors need to decide their risk tolerance first before they can average down. This method puts more exposure in a specific stock, which can magnify gains and losses. If you are ready to ride out the volatility with hopes of recovery in the long run, then averaging down can be included in your strategy. If you want to play it safe, you can drive clear of this method.
Diversification and Portfolio Balance
Averaging down could be more risky for those investors who already hold a high concentration of a specific stock or asset in their portfolio. It’s necessary to keep your portfolio diversified and balanced in order to lower the effect of poor performance by any single asset. Averaging down on a single position may influence your portfolio’s balance and raise the level of risk.
Market Conditions
In highly volatile markets, averaging down is extremely enticing when the prices appear to be below their historic averages. Market conditions never truly reflect long-term recovery. It is advisable to determine whether the dip is a part of the overall economic condition or of the asset you are thinking of.
When You Should Avoid Averaging Down?
While averaging down works in some contexts, it is a technique which must be executed with care. There are a few situations wherein you must avoid averaging down:
If the Fundamentals of the Stock Have Altered
If the fundamentals of a stock are declining, including declining revenues, increasing debt, or shifting industry trends, then averaging down wouldn’t be worth it. Even more money is lost in the long run through investing more within a fundamentally unhealthy stock.
If the Market Is in a Bearish Trend
During a prolonged bear market, averaging down is dangerous. Although it appears as though you are purchasing in a downtrend, the general trend of the market may last longer than you might ever think. It is hard to catch the rebound, and waiting for a stock to return to its worth may occur longer than you think.
Averaging Down in a Bear Market: Is It Worth It?
In a bear market, averaging down is simple, but be cautious. Some stocks recover, while others do not. First, find out if the decline is short term or long term before you average down. If you are uncertain, simply wait for the market to balance. It would also be best to consult your financial advisor and make the better choice under the situation.
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Conclusion
Averaging down can work well if executed well, but it has dangers as well. The problem lies in assessing closely the long-term future of the asset, your level of risk tolerance, and market conditions before investing more money. Averaging down properly can decrease your cost basis and set you up for future gains, but you are always smart to approach it cautiously with full knowledge of what the market is doing. Here at VSRK Capital, we suggest clients consult with a financial planner and do some homework months before attempting to apply this technique to their account.
FAQs
When should I average down?
To determine if you should average down, look at the long-term prospect of the asset, why it has fallen in price, and if the company or asset fundamentals are still in place. If you think the fall is temporary and the asset will likely rebound, averaging down could be considered. But if the fall is structural, then it would be best not to average down.
Should you average down during a bear market?
Averaging down during a bear market is dangerous as market declines can be longer than anticipated. Certain stocks might recover, but others might not. You must take into account the long-term prospect of the asset and not average down if fundamentals have deteriorated or the market decline is caused by structural issues.
Should I get a financial advisor’s advice prior to averaging down?
Yes, it is advisable that you get a financial advisor’s advice prior to averaging down. A financial advisor like VSRK Capital will help you analyze the risks, check the likelihood of recovery of the asset, and make sure that averaging down is part of your investment strategy. Their advice will assist you in making informed decisions, particularly in volatile market conditions.
