“Averaging up” is the practice of buying a few shares of stock or a commodity at a time as the price increases. For example, you buy 10 shares of a stock at $20 on day 1, buy another 10 shares at $21 on day 2, and so on until day 11 when you buy 10 shares at $30. By this point you have 110 shares of stock with an average price of $25.90. Investors average up when they don’t have enough money to purchase as much stock as they wish to but they don’t want to wait until the stock is expensive.
“Averaging down” works in the exact opposite way. You start buying stock at a higher price and gradually buy it at a lower price. Many naive investors believe that if you see a stock price declining then that is a good time to buy. However, professional investment fund managers often criticize this strategy because — as they say — “there is a reason why that stock is declining”.
So while averaging down may look like a good deal, it may in fact cost you a lot of money. Unless you have clear proof that the stock normally trends downward at certain times of the year (which does happen for some stocks and mutual funds) you are being speculative and putting your money at risk.
Buying on the downtrend is a marginally acceptable practice. You can justify doing this if you need to invest money now and you project a better return on your investment (when you sell on the uptrend) than if you were to move your money into another fund. Still, if you can find stocks moving up with a strong projection of continued upward movement, it is probably better to invest in those stocks.
Investing in the stock market is not as simple as people would like it to be. You can invest in the short term and “play the market” or you can invest in the long term and participate in company ownership. Long-term investors don’t need to worry as much about whether a stock price goes up or down, although any extended loss in value is well worth investigating.
Some investors buy stocks on the downtrend in a speculative fashion. This is called “shorting” the stocks, where they “borrow” stocks from their brokers and sell them at the current price. After a certain amount of time has passed the brokers needs the stock back and the “short” investor must then buy the stock at the current price, returning it to the broker. If the current price when the “short” investor buys is lower than when he sold, he makes a profit.
Shorting a stock is considered to be riskier than normal investing because your downside is unlimited. If you buy a stock for $50 a share the most you will lose if the stock is completely devalued is $50 a share. But if you SHORT a stock at $50 and its value only increases from that time forward, the longer you wait to buy back the stock the more expensive it becomes.
It is considered even riskier to average up or down on shorting stocks. You have to manage your money and your expectations carefully. The stock market performs according to certain principles and even in cycles but any unexpected disaster can shock a market into incredible downward trends; likewise, an unexpected wave of good news may cause a market to start shooting up in valuations. Short traders thrive on bad news and hate good news.
If you want to “average down” then you really want to short a stock that looks like it is in a long-term decline but which will bottom out at a reasonable price. If the stock looks like it is heading to 0 value people will stop investing in it and that leaves you holding the stock with no hope of recovering any of your money.
So, in the long run, it is better to average up when you find stocks that have good long-term prospects and it is better to average down when you find stocks that are relatively safe to buy short while they trend downward.