August 13, 2009
– Comments (2)
in the last month lots of momentum based stocks rallied hard, but I sold many of them in the last few days and keeping and adding more IBD type stocks instead for the nearterm.
Averaging Down - Good Idea or Foolish Risk?
By Ken Little, About.com
Averaging down is a strategy to lower your average cost in a stock that has dropped in price. Is this a good idea or throwing good money after bad?
The answer depends on several factors. First, let me describe how it works. You buy 500 shares at $50 per share, but the stock drops to $46 per share. You then buy another 500 shares at $46 per share, which lowers your average price to $48 per share.
Admittedly, this is a simple example, but you get the idea.
Now, is this a good strategy or not? If the stock rebounds to $60 per share, then it was a great strategy. However, if the stock continues falling, you have to decide to keep averaging down or bail out and take a loss.
Which brings us back to the question, is averaging down a good strategy or not? Before we can answer that question, we need to decide if we are investing in a stock or a company. The distinction is very important.
In most cases, you don’t know enough about the underlying company to determine if a drop in price is temporary or a reflection of a serious problem.
Your best course of action when investing in a stock (as opposed to a company) is to cut your losses at no more than 7%. When the stock drops that much, sell and move on to the next deal.
If you truly believe in the company, averaging down may make sense if you want to increase your holdings in the company. Accumulating more stock at a lower price makes sense if you plan to hold it for a long period.
This is not a strategy you should employ lightly. If there is a heavy volume of selling against the company, you may want to ask yourself if they know something you don’t. The “they” is this case will almost certainly be mutual funds and institutional investors.
Swimming against the current can sometimes prove profitable, but it can also get you swept over the waterfall.
Since I don't imploy anyone to average down, selling the momentum stocks before they fall after their massive gains is the best course of action at this point of time. Once they correct I will be a buyer again.
But for now the better value is in the IBD listed value plays. One such play is Dr. Pepper Snapple