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

Tip of the week: “Don’t let share prices distract you from portfolio diversification and investment quality.”

Sometimes a stock moves downward and creates what we consider a buying opportunity. We apply the term when we feel an attractive stock has dropped in price for reasons that are of a passing nature, or that are exaggerated in investors’ minds.

This shouldn’t be confused with “averaging down.” That’s when you buy more of a stock you own that has fallen in price, mainly to lower your average cost per share. However, following an “averaging down” strategy is almost certain to cost you money in the long run. Here’s why:

• Averaging down is entirely focused on share prices. The main problem with averaging down is that you are picking stocks based on a single factor: the drop in the price of the stock — and not the company’s overall investment quality or the stock’s place in your portfolio diversification. This focus on share price can be highly detrimental to your portfolio investing results over the long term.
• Unknown negatives can cause stocks to drop — and keep falling. Some investors go through a phase when they reflexively buy more of anything they own that goes down, as if to validate their decision to buy it in the first place. Stocks sometimes go down due to random fluctuations and misinformed selling. But they also fall because of negative factors that the public does not yet know about or appreciate.

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• Averaging down with aggressive investments is especially risky. In the case of aggressive stocks, averaging down can be one of the worst mistakes you can make. That’s because there are more likely to be hidden risks in aggressive stocks. With conservative stocks, averaging down is still risky. Good stocks do go bad. Stocks that are generally considered conservative do sometimes turn out to be anything but.
  
  That’s why we always recommend that you consult our newsletters and investment services, including our flagship publication, The Successful Investor, for changes in our buy/sell/hold advice before you buy more of a stock that has dropped significantly. If we continue to recommend the stock as a buy, that means we think the stock will turn out at least okay, or perhaps much better than that. But it’s important to note that no one can predict such things with 100% certainty.
  
  Moreover, you should weigh the impact that buying more of the stock would have on your portfolio diversification. If buying more would put the stock above, say, 5% of your overall portfolio, we would advise against it.

Our investment advice: Portfolio diversification is key to your success as an investor, and you should never make the mistake of investing too heavily in any one stock, regardless of how certain you are about its future. Let’s put it this way: The only time it pays to average down is when it’s a coincidence. You want to buy more of a stock because it’s attractive, not because you bought it at higher prices.

Next Wednesday, February 2, 2011, Investor Toolkit will look at the hidden pitfalls of stop-loss orders.

You can get our latest analysis, including our clear buy/sell/hold advice, on dozens of Canadian stocks you may be considering buying in The Successful Investor. What’s more, you can get one month free when you subscribe today. Click here to learn how.