First of all, it's not a question of initially acquiring a stock whose price has fallen, which can lead to a handsome capital gain, but rather of strengthening a position that you wouldn't have strengthened if the stock had risen, simply because of a fall in price.

Nor is it the DCA (dollar cost average) method, which involves regularly investing the same amount up and down. In this case, we invest in both our losing and our winning stocks, whereas with dollar cost averaging, we only strengthen our losing stocks.

Finally, this is not a position on an index, an ETF or a long-term investment in a solid stock, but a bet on a small isolated stock.

What are the risks of this method?

  • By strengthening a stock on the downside, we risk unbalancing our portfolio on one or more stocks that are, moreover, in a bad way.
  • By becoming accustomed to making downward averages, investors refuse to recognize their error. If a stock seems attractive at 100 euros and then falls by 30%, you need to question yourself and your approach as an investor, rather than assuming that the market is wrong.
  • In doing so, it's highly likely that we'll realize that our initial analysis was wrong, that we've missed out on some important information, especially if the market as a whole has not followed the same direction.

Let's take a concrete example, with a former tech bubble star (such as Docusign, Shopify, Roblox, Robinhood, etc.). An investor invests $5,000 in Zoom in August 2021, at around $400, well below the highs of $588, with a 30% discount. In December 2021, the share price has fallen by 50%, and the investor buys back $5,000. In March 2022, the value has given up another 44%, falling to $111. In all, the investor has lost $5825, more than his initial position.

When can you average down?

  • If the gradual entry was already planned: if you had planned to enter a stock two or three times, and it fell sharply after your first purchase, you'll have the opportunity to redo your analysis to understand the reason for the drop (general market decline or just the stock? Disappointing results or rumours? etc.). If you're still convinced of the timing, you can allocate the remainder of the capital originally planned. In the opposite case, you will have been right to invest only 50% of the initial amount, and will only be risking half of your position.
  • If you are strengthening a global portfolio or a position in broad indices (MSCI, Stoxx 600, ETF), as indicated in the preamble.
  • If they are quality stocks, i.e. profitable, not very cyclical, with a sound financial situation, that you know well and whose downturn you understand. Because a sharp downturn can be the sign of the beginning of a decline.

When should I avoid the downward average?

  • If the company is unprofitable.
  • If the valuation is too high. In Zoom's example, the stock had reached a PER of 800 by 2020. Remember that the higher a company's price, the greater the potential for downside and market disappointment.
  • On small caps. By definition, small caps are more fragile, less diversified (in terms of products, customers, geographic zones) and have more fragile balance sheets. The risk of bankruptcy is higher than for large-cap stocks. They are also more subject to insider selling, and less covered by analysts. With less information available, you're likely to be the last to know about bad news.