We recommend an averaging in over an average down stock investment strategy. Averaging in lets you add more of stocks that have sound prospects. Averaging down often does just the opposite

“Averaging down” and “averaging in” sound similar, and their meaning is similar as well. Both are investment tactics that let you rely, in part or whole, on price changes rather than facts to make investment decisions.

A wide gap separates the two, however, and mixing them up can cost you money. Averaging down is something of a face-saving tactic, and most people use it only on occasion. Averaging in can be part of a disciplined, proven approach to successful investing.

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What it means to average down stock picks

Averaging down is the tactic of buying more shares of a stock you own as the price falls. The idea is that this will cut your average cost per share. That way, you make more money (more per share, at least) when the stock turns around and goes up.

One problem with averaging down is you are betting you were right when you bought the stock in the first place. You assume your $20 stock pick is an even better buy at $15. You may be right. Or, you may be dismissing warning signs that drove the stock down, because you don’t want to admit you were wrong.

If you routinely average down stock picks, you introduce a negative filter into your investment process. Rather than regularly reassessing your holdings, you zero in on your losers. You ignore the risk that stocks sometimes drop due to newly emerging or hidden problems.

Stocks sometimes do go down due to random fluctuations and misinformed selling. But they also go down due to problems that the public does not yet know about or understand.

Don’t buy just to average down stock picks

As mentioned, averaging down does lower your average cost per share, but the fact is that it can cost you money in the long run. At the same time, you run the risk of distorting your overall portfolio management strategy.

Here are three problems that crop up with averaging down:

1. Averaging down ignores investment quality.
2. Hidden problems can cause a stock to fall—and keep falling.
3. Averaging down can spell disaster with aggressive stocks.

Practice “averaging in” instead of “averaging down”

Averaging in is much more likely to make money for you. This is the practice of adding a fixed or rising sum of money to your portfolio on a fixed schedule every year, regardless of your view of the stock-market outlook.

When you make a habit of averaging in over a period of years if not decades, you are betting that the stock market will go through fluctuations, but will continue to rise over a lengthy period. That’s the smart way to bet, because the market does indeed tend to go up over long periods.

Habitual averaging-in also makes investing simpler. You no longer need to have an opinion on the short-term outlook for the market.

If you regularly average in, you will at times add money to your portfolio just before a plunge in stock prices. Other times, you’ll buy more stocks just prior to a rise. But over long periods, you’ll automatically buy more often when the timing is good and stocks are headed for a rise. That’s because stock prices go up more often than they drop.

The beauty of averaging in is that by investing the same sum every year, you automatically buy more shares when prices are low, and fewer when they’re high. The tactic works best when you apply two conditions:

1. You start doing it early in your investing career, when you can safely assume you’ll have enough income to make your scheduled cash addition to your portfolio for at least several more years, if not a decade or two.
2. You stick to your commitment, through good years and bad.

Focus on investment quality when averaging in

Well-established companies are the key to profitable and lower-risk investments. Instead of moving between extremes of risk, we continue to think investors will profit most—and with the least risk—by buying shares of well-established companies with strong business prospects and strong positions in healthy industries. That’s not to say that there won’t be surprises that affect every company in a particular industry. But well-established, safety-conscious stocks have the asset size and the financial clout—including sound balance sheets and strong cash flow—to weather market downturns or changing industry conditions.

Always use our three-part Successful Investor approach for your overall portfolio. Here’s what to do:

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Some investors who practice averaging down will wait and watch as a stock price dives, and then will buy more shares at the first sign of the price going back up. They believe this lessens the chance of losing too much. How do you feel about this strategy?

An averaging down investment strategy relies largely on predicting the market. What do you think about strategies that take this approach?