Current Economic ClimateWith the Dow Jones Industrial Average and S&P 500 climbing into new territory almost daily and a large number of great stocks running in step, many investors are wondering if the markets are going to continue to run higher. And if so, should they sell, take some profit, or average up?
Normally, investors want to know if it’s a good idea to average down, not up. Averaging down is the art of buying more shares in a company at a lower price than you originally paid. This brings the overall average price you paid for each share down.
For example: you buy 10 shares at $1.00. You then purchase equal amounts at $0.90, $0.70, and $0.25; this brings the average price you paid per share down to $0.71. While there are legitimate times to average down, the majority of the time, it involves investors stupidly throwing money at a bad company—averaging down and down and down in the absence of any rise in share price.
Averaging up, on the other hand, is when you purchase additional shares in a company at a higher price than you originally paid, thereby raising the average price you paid for each share. For example, you buy 10 shares at $1.00, then buy equal amounts at $1.10, $1.30, and $1.75; this raises the average share price up to $1.28. Unlike averaging down, averaging up is the art of throwing good money at a great company.
Here are three reasons why it’s better to average up than average down in today’s market:
Relieves Stress: Investors don’t pair “averaging down” with “catching a falling knife” for no reason; after all, averaging down usually means you’re chasing a stock that isn’t performing well. The best way to avoid the headache of holding on to a losing stock is by buying a stock on its way up.
It sounds pretty simple, but for some reason, this straightforward logic doesn’t make sense to some investors. For them, it makes more sense to buy additional stocks in a troubled company than it does to invest in a company with growing revenues and earnings and an encouraging outlook.
It might hurt to admit you invested in a bad stock and take a financial hit, but it’s better to get out of a losing position than push the knife deeper. Avoid stress by averaging up in fundamentally and technically strong companies with momentum.
Momentum Is Good: A lot of investors like to fashion themselves as stock market dandies, locating obscure stocks with great upside potential. In a bull market like this, where the Federal Reserve, pension funds, and bond funds are pouring money into the stock market—and will continue to for the near future—there’s no shame in making money by buying profitable stocks with solid momentum.
In fact, earnings season is a great way to test out the “averaging up momentum” theory. Share prices generally rise when a company announces solid quarterly revenue growth and earnings or, better yet, beats expectations. Many investors average up into the earnings momentum.
More Money!: Investors often talk about finding stocks that have doubled, tripled, or quadrupled in price. Oddly enough, few of them averaged up on those investments. That’s probably because they didn’t truly believe in them and were just holding on for the ride.
But if you believe in a stock and the underlying economic indicators, and truly believe the stock can double or triple in price from where it currently stands, then it would make sense to average up.
On the upside, averaging up can mean more profit. On the downside, averaging up means you are heavily leveraged in one stock, so any negative turn in sentiment could be ruinous. Averaging up isn’t foolproof—nothing on Wall Street is. But following profitable stocks is always a better tactic than chasing a losing stock.
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