Averaging down consists of buying fractions of your intended total position at several descending prices. This is opposed to buying a full position at one price. Averaging down has many benefits for long term investors desiring to maximize total returns. To be clear, averaging down must be the plan from the start, not a way to make up losses. Also, it is meant to be used in investments not trades.
Here is an example, taken from the Energy Select Sector SPDR (NYSEARCA:XLE).
Buying higher-weighted positions at lower prices brings the average costs towards the lower range. In this example the average cost is $47.39. The following is a list of benefits inherit in this strategy.
Averaging down makes it more likely to achieve a lower average cost
Picking bottoms is a very difficult practice. Many investors do not even attempt to do it. On the other hand, rushing in prematurely may be a costly mistake. In the above example, there are several appealing points of entry for the XLE. Buying a full position at $55.50 may leave an investor burned if oil prices tank. A small position will bring some profit if oil prices stay afloat. Trying to buy a full position at $42.50 is also problematic. It is trying to pick a bottom, and if it gets close but not all the way the investor will miss out completely. Averaging down is a balanced approach towards building a well-priced position.
If your entire position is not filled it is often a good sign
If your third position is never filled, there is a good chance you are making money on your other two positions. You miscalculated the company's downside and it is in better shape than you realized. While this is not a steadfast rule, you will often find yourself in winning positions that otherwise you would not have had the conviction to enter right away.
It helps you be patient and disciplined
Impulsive people like myself get really excited about a company and want to go all in right now. This is almost always a mistake. Averaging down makes you wait, sometimes a long time, for your price. Instead of chasing prices you will have the prices chasing after you. You must also have the discipline to sit tight and not change your orders due to market elation or fear. Having a solid plan helps overcome market psychology and keeps us calm during periods of turmoil.
You anticipate market pullbacks instead of being afraid of them
There is no worse feeling than selling a great company at the bottom due to excessive fear. People who buy full positions prematurely often suffer from this. When you average down you find yourself anxiously awaiting the next market drop so you can get filled at your final dream price. There is no better feeling than getting something you have wanted for a long time at a sizeable discount.
You may find more attractive opportunities and not have to suffer tax losses to buy them
New investment ideas present themselves frequently. When fully invested, it is sometimes more profitable to pass them up due to the painful taxes incurred upon selling your position to free up the cash. With averaging down you have more time before reaching a full position. You can simply cancel your remaining orders and use that money for a better investment opportunity should one present itself.
There are a few drawbacks to this approach. Sometimes positions will not get filled completely and you may find your portfolio with too many small positions. It is difficult to watch numerous companies closely. Also, investors who have the rare gift of picking bottoms would profit less from this strategy. I personally have never met such a person, but theoretically one could argue that investors with excellent market insight would do better buying full positions. Another problem is increased commission costs due to a higher volume of trades.
Averaging down is for people who prioritize safety. Yes, you may not get as rich playing conservatively, but for investors seeking to maintain and steadily grow their portfolios without subjecting themselves to high risk would do better with this approach. I believe in the long run you will improve performance by giving up a few gains for the superior balance and more favorable pricing of your portfolio.