Editor’s note: This article was first published in August 2013; the Banco Popular price levels it uses as examples, including the moving average, support level and all-time low, are from that time. The trading levels below date from August 2013 and are not investment advice. Banco Popular was resolved and sold for one euro in 2017, wiping out its shareholders.
Briefly, here is what averaging down on a stock means: “If we buy a stock at €20 thinking it will go up, and the stock starts to fall, averaging down means buying again lower down, so that when it rises we will have made much more. In other words, we buy 1,000 shares at €20, they fall, and we buy again at €10. As soon as they get back to €20 we’ll be in profit, and so if the price rises to €30, our investment will have been much more profitable thanks to averaging down.”
That said, to average down on a stock we need to be very clear that we are in it for the long term and that the stock is worth holding for the long term, and sometimes averaging down is not the best idea. In certain situations, depending on what is happening, it might be wiser to sell our shares and take a bearish position.
When to average down
To do it intelligently we should use technical analysis to average down at key support levels. Of course, if a stock is making all-time lows, we won’t have a clear reference for where its fall might stop.
We always say that before buying shares we should be very clear about the strategy we are going to follow, and we should already have worked out every scenario that could arise: “What will I do if it rises 50%? What will I do if it loses 15%? And if it loses 50%?” Above all, we need a very precise point at which we would buy more shares, and we should try to make as few exceptions as possible, although in the stock market you sometimes have to improvise, because a scenario regarding the company that we hadn’t anticipated may arise.
Here is an example.
On Banco Popular’s chart, the default zone to average down would be the 200-session moving average, at €3.08. But what if we average down and the price falls below the moving average? Opinions differ in this case, and everyone has their own point of view.
See also: The essence of smart investing for building wealth in the stock market over the long term
Personally, I wouldn’t average down in that zone, but rather near an older support level, at around €2.60. In my case, when it comes to averaging down, specifically on a stock like Banco Popular, I would only do it right in the middle: between the 200-session moving average and €2.60, which works out at roughly €2.75–2.85, depending on how the markets are doing at the time, of course.
Victoria Bernal has a different method. She would invest half the money she had set aside for averaging down at the first support (the 200-session moving average) and, if that fails, use the other half at the next support. I’ll say it again: many variables can come into play by the time the stock reaches those points.
I also know others who would only average down close to Banco Popular’s all-time low, at around €2.32.
Others work it out purely in percentages: “If it falls 15%, I buy more.”
How do you average down when a stock is making all-time lows?
That part is very dangerous, because when a stock is in free fall nobody knows where it might end up. But one thing is clear to us: if it’s a company we like and we believe it has potential, the lower it goes, the better for us. In these cases it would be a matter of analysing many more of the stock’s technical factors and looking for a psychological stopping zone, such as the one-euro mark or a round number. If we add fundamentals to the mix, that point is more or less when we consider the stock a bargain.
If we average down correctly, we can increase the return on our investment portfolio considerably. But remember: even something as simple as averaging down becomes an art in investing.
See also: James Montier’s 7 immutable principles of investing
Featured image: Kippelboy, CC BY 4.0, via Wikimedia Commons.
