Wait until the stock is back to where you bought it, and you may be waiting for a long time. As well, this philosophy sometimes makes investors sell at break-even when the stock is moving past the buy price and into even higher territory.

Averaging Death - Er... I Mean Averaging Down
Averaging down is when you buy more shares of a stock after it has sunk. This makes your average price per share lower. For example, you bought 1000 shares at $2.00, the stock sinks to $1.00 and you buy 1000 more. Now you have 2000 shares of stock at an average price of $1.50. This can be beneficial as the price only needs to increase 50% now to get back to break even, rather than 100%.

However, be warned. Averaging down is just throwing good money after bad, and very rarely works out to the advantage of the investor. You already expected the stock to go up, and it went down. Now you are doubling your position in a stock that is not performing as you would like. Your fresh money may be better spent going into an entirely new stock altogether, as then you can pick from a pool of thousands, rather than putting more cash into a sinking ship.

Danger - Thin Ice
Well, you might say the stock can't sink forever and eventually it has to rebound. This is the main argument that people use to justify their methodology of buying more shares.

However, there are some factors that you may not have considered which can really hurt a stock price without being very visible. For example, often a wounded stock will consolodate shares (commonly referred to as a reverse split). All of the sudden the stock price doubles but you have half the shares. This gives the underlying stock room to continue its decent from a higher platform. Usually after a reverse split shares do decline in value in the short term.

Another problem would be if the company is in real trouble. The shares could keep sinking until $0.00. This is the only 'guaranteed' price bottom you'll ever find, and if anyone tells you different they are not being forthright. In such a case averaging down is a really bad idea.

When Is Averaging Down Effective?
After considering what we have said above, there are exceptions for averaging down. Perhaps the company is solid, with earnings and improving revenues. Maybe the stock price has simply been decreasing in sympathy to the overall market, or along with its sector.

If you feel strongly about the company, from an educated rather than emotional standpoint, then averaging down can be effective. That is, of course, if you are right about the company.

Don't sink all of your cash into a stock at first. It is often good to buy half or a third of what you can afford, then give the stock some time to perform. If the shares increase you've made some money. If they sink, you have money held back to average down (as long as the company is strong and is simply being undervalued).

Many professional traders 'Average Up' which is buying more shares only if the price begins to rise. The increasing shares prove that they were right to pick the stock and gives them confidence in their research methods. If the company is in a long term uptrend they'll be making plenty of money on the shares, especially since they increased their exposure.

Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice. For further information please read our disclaimer.