I have received a number of emails and private messages the past couple of days seeking my advise on whether they should “average down” their shareholdings in a company.

This post was originally posted here. The writer, Lim Jun Yuan is a veteran community member and blogger on InvestingNote, with username known as ljunyuan and has 1055  followers.

While I am unable to give you a definite answer on whether or not you should “average down”, as all investors think and do things differently, and are unique in their own ways, but there are a few things (3 in particular) you can ask yourself which I hope will help you make the final decision.

Before I reveal what these three things are, let me first talk a bit about what does “averaging down” mean (for those who may be hearing about this for the first time) – in layman terms, it simply mean you increase your shareholdings in a company that is currently trading at a lower price, and in so doing, you bring down the average price of your shareholdings in the company.

To explain this with a simple example, let’s say you originally have 1,000 shares of Company A at S$10.00. However, the share price of Company A is now trading at just S$5.00, and the act of “averaging down” means you increase your shareholdings in Company A at its current trading price; assuming you decide to buy another 1,000 shares at S$5.00, then the average price of your shareholdings in Company A becomes S$7.50 now, which can be calculated as follows:

Initial Purchase: 1,000 shares x S$10.00/share = S$10,000

Additional Purchase: 1,000 shares x S$5.00/share = S$5,000

In total, you have now invested a total of S$15,000 in 2,000 shares of Company A.

As such, your average price in Company A is S$15,000 divided by 2,000 shares = S$7.50

Now that you have a better understanding of what “averaging down” means, let me share the three things you can look at to help you decide whether or not you should do so:

1. Find out Why the Company’s Share Price have Gone Down

There are three reasons why the company’s share price have gone down, and they are: (i) business fundamentals failing, (ii) one-off temporary event, and (iii) a combination of both.

Personally, I feel that if the share price of the company have gone down because of weakening business fundamentals (for instance, you noticed the company’s top- and bottom-line have declined over the years, along with its dividend payout to shareholders, and that there are no signs of a turnaround), then you will be better off cutting your losses by disposing of your shareholdings in the company and re-invest this amount of money into other fundamentally sound companies which can offer you a much better return on investment.

On the other hand, should the fall in the company’s share price be due to a one-off temporary event, and that the company’s business fundamentals remain intact, then you may want to seriously consider taking advantage of the drop in share price to “average down” your shareholdings in it, and in so doing, increase your dividend yield, as well as enjoy capital appreciation when the share price recovers later on. However, before you do so, you need to consider the possibility of portfolio concentration.

 

2. Consider about the Possibility of Portfolio Concentration

There are no hard and fuss rules as far as portfolio concentration and diversification is concerned – some investors are geared towards the former, while some are geared towards the latter. Whether is it portfolio concentration or diversification, you need to be comfortable with it.

That said, before you make any decision to “average down” your shareholdings in a particular company, you may want to do some calculation to find out the weightage (in terms of percentage) of this company in your overall portfolio currently, and the weightage of the same company in your overall portfolio after you’ve “averaged down.” Thereafter, look at the percentages (both before as well as after) and ask yourself if you’re comfortable with it.

 

3. Opportunity Cost

Finally, I’m sure all of us have a cap as to how much money we have to invest. Therefore, we need to also consider the opportunity cost.

What this means is that, if you decide to allocate a certain amount of money (from the pool of money we have set aside to invest) to “average down” on a company, then there’s a possibility that you may miss out on other investment opportunities which may come your way down the road (some of them may generate an even better return on investment than the company you’ve “averaged down.”)

You need to be fine with that as well. However, this concern is irrelevant for those who have massive amounts of cash side aside to build their investment portfolio.

 

In Conclusion

With that, I have come to the end of my post. For those of you who are unsure of whether or not you should “average down” your shareholdings in a company, I hope that the above will help you make your eventual investment decision.

 

Thanks for reading.

Once again, this article is a guest post and was originally posted on ljunyuan‘s profile on InvestingNote. 

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