While managing your investment portfolio, there are certain ways you can boost your returns upwards. One of them is averaging down. Our best example where we used this strategy, was when a stock we then recently bought fell down in price hard. We did what every investor would do, we worried a bit. If you experience something similar, questions which can pop up in your head could be: Should we sell? Wait it out? What if the market know something you don’t? We bought stocks of a fundamentally good company, but didn’t really knew the business behind it. Back then we bought it high priced and soon after, it became our worst performing stock in our portfolio. But we managed to turn it around. How? Because we averaged down on a good company.
We just started out with investing a few month before. With all the upside potential in telecommunication and internet of things we decided to buy the Dutch company BE Semiconductor Industries ($BESI). This company is fundamentally solid with lots of growth potential for the long term. We looked at all the financial metrics. And after some time reflecting and evaluating, we bought it. Without hesitation. But what we didn’t knew, is that we bought the stocks at the peak of a market high. After a few weeks the price fell down from a nice €28 per stock to €22 over just a few days…
So after lots and lots of long talks about our nagging situation, instead of selling or waiting, we decided to buy more. Or better known as averaging down.
Investopedia describes it as the following:
Definition of ‘Average Down’
The process of buying additional shares in a company at lower prices than you originally purchased. This brings the average price you’ve paid for all your shares down.
We have to point out, that averaging down can be a good as well as a bad strategy. When a stock plummets, it can also happen that the stock will be turning into a falling knife, where the fundamentals of the company are at stake. Such a stock will not easily or sometimes never recover to a higher price range. When this is the case, it’s best to sell the stocks. When you are confident that there are other circumstances however, you could decide to average down.
In our case BESI is a semiconductor company. The market of semiconductors behaves in a very volatile manner. Similar in the way with mining companies, like Caterpillar ($CAT). This means that companies staged in this sector are very depended on market circumstances. With BESI, there was a lot of negative market segment because of slower demand of emerging markets and disappointing iPhone sales. The downfall of the stock price was due to macroeconomic factors, hence we decided to buy more stocks and average down on this company.
If the cause of the declining market price would fit within micro-economic frameworks (on prudential level within the company itself), or within meso-economic (within the industry and environment), you should be very careful. This would mean something about the fundamentals or the industry itself are dead off wrong. When this happens, you will be better off to sell your stocks.
How it works
The first time we bought stocks of BESI the price was at €28, the second time already at €21. But because the price was continuing to go down, we bought more stocks for a third time with a selling price of €15.
So we began with a cost basis of €28. Because we bought not only twice but three times in a short period, we managed to average down our cost basis to €19.5. This is -30% decrease.
When the stock was on the rise again, we not only doubled but tripled in higher returns because in the meantime we build up to 124 stocks. Besides, as soon as the stock price hit the €19.5 we started making money, instead of the €28 we had at the beginning.
Currently BESI is amongst the best performing stock with a return of +30% and a very attractive dividend yield of 4.4%. So including the dividend, which will probably grow every year, we even manage to have an outstanding total return.