Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment advice. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “Buying more shares of a stock when its price is down may seem like a bargain, but it can actually turn into a costly trap for investors.”

A bargain is generally regarded as a good thing. What could be a better bargain for investors than buying shares of a stock at lower prices?

“Averaging down” is the well-known market tactic by which investors buy more shares of a stock that has come down in price.

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.

”Averaging down” can lead investors into these 3 traps

Here are three problems that crop up with averaging down:

1. Averaging down ignores investment quality. Many investors have made lots of money by “averaging in” to the stock of a well-established, well-managed company — that is, buying more as funds became available over a period of years. “Averaging down” is not the same thing. When you systematically average down, you are zeroing in on your losers and running the risk of hurting your stock market returns. It’s true that good stocks can drop and stay down for lengthy periods. But bad stocks are more likely to go down and stay down. If you routinely buy more of any stock you own that goes down, you run the risk of loading up on your worst choices. That costs you money. It will also depress your stock market returns because it keeps you from buying good stocks, due to the fact that your available funds are tied up in bad ones.
2. Hidden problems can cause a stock to fall—and keep falling. Some investors go through a phase when they buy more of anything they own whenever it goes down. It’s as though they want to validate the decision they made to buy it in the first place. Stocks sometimes go down due to random fluctuations and misinformed selling. But they also fall due to festering problems that the public does not yet know about or appreciate.

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3. Averaging down can spell disaster with aggressive stocks. Hidden risks are more likely to lurk in aggressive investments. Even with conservative stocks, averaging down is risky. Good stocks do go bad. Stocks that are generally considered conservative sometimes turn out to be anything but.

Before you buy more of any stock that has dropped significantly, we recommend that you consult our investment newsletters for changes in our buy/sell/hold advice. If we continue to recommend the stock as a buy, that means we think the stock will be okay at the very least, and perhaps much better. But keep in mind that no one can predict such things with 100% certainty.

Moreover, you should consider any purchase in light of your overall portfolio. What impact will it have on the whole? If buying more would put the stock above, say, 5% of your overall portfolio, we generally advise against it.

One key part of good portfolio management is to avoid investing too heavily in any one stock, no matter how optimistic you are about its future.

Our investment advice: It only pays to average down when the fall in the share price is a coincidence, and you just happen to get the stock you like at a lower price. You want to buy more of a stock because it continues to be an attractive company, not because you bought it at higher prices.

COMMENTS PLEASE—Share your investment knowledge and opinions with fellow TSINetwork.ca members

In general, are you more inclined to buy stocks when they are rising in price, or falling? Or do you consider price a secondary factor in relation to the overall quality of the stock? Do you have a specific example of “averaging down” to buy a stock at a low price and having it pay off with a big surge? Let us know what you think.