Averaging strategies are commonplace in the world of investing (and trading). The two straightforward averaging approaches are “average down” and “average up”. If you do not know what are the ups and downs, here is a brief introduction to these terms.
According to Investopedia1, the definition of average down is:
The process of buying additional shares in a company at lower prices than you originally purchased.
This averaging strategy is usually used by investors (and traders) when the price of their shares (and other financial instruments of other asset classes as well) goes below their original purchase price. By buying more of the shares at the lower price, the average price of the entire holding would be lower than the original purchase price.
For example, I had bought 100 shares of ABC Company at $1.00 each, totalling $100.00. A few months later, the price had gone down to $0.80. I then bought another 100 shares at $0.80, making it $80.00. In all, I have 200 shares of ABC Company worth a total of $180.00 ($100.00 + $80.00), or $0.90 per share ($180.00 / 200), thus averaging down from my original $1.00 position.
There are a few reasons for this averaging down. One of which is to bring the average price to a level where it is “nearer” to the current price, thus making it “easier” to exit at that price (quoting the above example, it is “easier” for a share price to go from $0.80 to $0.90, than from $0.80 to $1.00; do note my quoted easier, however). Another reason is the investor could buy the shares on the cheap.
Average up is the opposite of average down, where it is the process of buying additional shares at higher prices.2 Using the ABC Company example again, I had bought 100 of its shares at $1.00 each, totalling $100.00. A few months later, the price went up to $1.20, during which I bought in another 100 shares, paying $120.00. The average price now would be ($100.00 + $120.00) / 200 = $1.10 per share, averaging up from $1.00.
Investors typically use averaging up when they see there is a potential for a particular share to go further up, therefore adding more positions to it.
Are These Strategies Good for The Bedokian Portfolio?
There is nothing wrong with averaging down or up; a form of this strategy is being recommended for index investing3 in The Bedokian Portfolio. Also, in my previous blog post on rebalancing woes (see here), one of the solutions proposed is to add positions to current holdings, which will definitely involve some averaging down or up. Whether up or down, especially for individual equities, bonds and REITs, fundamental analysis4 and the selection guidelines5 must be adhered to.
1 – Investopedia. Average Down. http://www.investopedia.com/terms/a/averagedown.asp (accessed 29 Sep 2016)
2 – Investopedia. Average Up. http://www.investopedia.com/terms/a/averageup.asp (accessed 29 Sep 2016)
3 – The Bedokian Portfolio, p 60 & 122
4 – The Bedokian Portfolio, Chapter 11 – Fundamental Analysis
5 – The Bedokian Portfolio, Chapter 12 – Selection and Selling