Many novice investors, and some experienced ones, have a tendency to "average down" on a stock that falls in price, on the basis that they are picking up additional shares at an "even better price". Yet most professional traders regard averaging down as a cardinal sin, amounting to throwing good money after bad.
The irony is that the trading (in the form of spread betting) method of betting "per point" can lead us in the direction of a safer way for investors to average down.
The lure of averaging down
If you buy £10,000 worth of a stock at 100p-per-share and it falls by 50%, you will need a subsequent 100% rise in order to take you back to break-even.
If you pick up another £10,000 worth of the stock at the lower 50p-per-share, you are holding £15,000 worth of stock which cost you £20,000. So you need only a 33.33% recovery to take you back to break-even on your combined holding.
This is why investors like averaging down, and when it comes to pound-cost-averaging into an index tracker... it might just work.
The problems of averaging down
The first problem of averaging down in this way is that, when making your second investment, you doubled your value-at-risk from £10,000 to £20,000.
The second problem of averaging down (specifically on a single stock) is that a share that has fallen by 50% can easily fall by another 50%; so then you have to do it again, and this particular stock becomes a magnet for funds that might be better deployed elsewhere.
Each time you invest an additional £10,000, it's another £10,000 that you stand to lose entirely when the company goes bust -- and lately, quite a few seem to do just that!
Pounds-per-point averaging down
If you place a £100-per-point spread bet on a stock priced at 100p-per-share, you are risking £10,000 as in the investment case. If subsequently you average down by placing the same size £100-per-point spread bet on the same stock, when it has fallen to 50p-per-share, you are risking only £5,000 the second time around. If it falls by 50% again, and you place another same size bet, this time you are risking only £2,500 more.
Personally I wouldn't go betting £100-per-point on a 100p stock, but it mirrors the investment case and demonstrates that pound-per-point averaging down incurs less additional risk at each turn.
Equal shares averaging down
What I've demonstrated, using the spread betting analogy, is the equivalent of investing in an equal number of shares (rather than making an equal monetary investment) at each turn.
With the stock at 100p-per-share, an investor can buy 10,000 shares for £10,000. When the price falls to 50p-per-share, the investor can average down on another 10,000 shares for just £5,000... and so on. The more the price falls, the less additional risk you are taking when you average down... if you purchase the same number of shares each time.
The downside of the upside
This is no Holy Grail, of course, because you are taking on less downside risk at the expense of lower upside potential.
Assuming just one round of averaging down, you will have bought 20,000 shares (now worth £10,000) for £15,000, so you'll need a 50% recovery to take you back to break-even rather than the 33.33% recovery required in the equal-value-invested averaging down.
The safer way to average down
So what if your profit potential is not so great? You still have more profit potential than if you hadn't averaged down at all, and by the third round I personally would rather have a total of £17,500 at risk than a total of £30,000 at risk. I would also rather have scaled into the position in this way than to have invested the full £17,500 at the original higher price.
The equal-number-of-shares (or equal pounds-per-point) approach to averaging down is an example of an anti-Martingale strategy, which is safer than the equal-value-invested approach to averaging down, and which in turn safer than the Martingale strategy of averaging down ever bigger amounts at each turn. I do hope you weren't considering the latter, as it can require infinitely deep pockets!
Foolish bottom line
Scaling into a position by averaging down can be more beneficial and less risky than investing all in one go. It can be made even less risky by purchasing equal numbers of shares rather than making equal-size investments in each round. This comes at the expense of lower profitability, but I did tell you that this was the safer way to average down and not the more profitable way.
I prefer the safety-first approach to looking after the downside and letting the upside look after itself. Why? Because companies can (and do) go bust, and then you've lost the lot!