When to Average Up and Down on Penny Stock - dummies

When to Average Up and Down on Penny Stock

By Peter Leeds

You’ll find much more success — and a lot less downside — by investing in penny stocks on the upswing rather than throwing your hard-earned cash at stocks on a downward slide.

The many downsides of averaging down on penny stock

Averaging down simply means buying more shares of a stock that you already own and that has fallen in price in order to lower your average cost per share.

The thinking with this sort of strategy goes like this: If you bought $1,000 worth of a penny stock at 90¢, why not buy another $1,000 worth now that it’s at 30¢? You would then have an average cost per share of 45¢, with a total investment of $2,000 into what is currently a 30¢ penny stock.

This type of reasoning can get you into a lot of trouble, though, and the general sentiment on the markets is that averaging down is simply throwing good money after bad.

Averaging down can be one of the most costly mistakes for investors. When a penny stock heads much lower, or even to zero, the traders who average down lose a lot more money than their original investment because they keep sinking more cash into the failing stock.

If the shares go back up after you average down, you may look pretty smart. However, the fact remains that you got the investment wrong in the first place, and a strategy of cleaning up your mistakes by averaging down will eventually catch up with you.

Typically, investors average down for the wrong reasons, among them the following:

  • To minimize a mistake. After buying originally, the shares fell. The investor doesn’t like being down such a hefty percentage, so she purchases more shares at the current lower price. She is now down on the investment overall, but the price of the stock compared to the average price she paid per share isn’t as great.

  • Because of misplaced faith in the company. Sometimes an investor is passionate about a penny stock’s prospects. She believes this company will change the world and make its shareholders millionaires. But if that were true, the stock probably wouldn’t be heading down.

  • To get a bargain. If an investor bought shares at higher prices, those shares seem like an even better bargain now. Penny stocks heading toward zero seem more and more compelling all the way down! Don’t be fooled.

  • They mistakenly believe that a lower price means a lower risk. Investors who believe that stocks become less risky as their price goes down are incorrect. With any purchase, even to average down, the investor risks 100 percent of what she puts into the company, whether the shares are at $20 or 2¢.

  • They’re missing an important piece of the puzzle. Even with proper due diligence, an investor may watch the shares slide. He doesn’t see the real issue that’s pulling the stock lower and so continues to trust in his findings — all the way down to lower prices.

The upsides of averaging up on penny stocks

Professional investors and successful traders don’t average down — they average up, meaning that they buy more of a stock they already own when it is increasing in price. When shares begin to move higher after your initial purchase, it may be a sign that this penny stock is beginning to move in the right direction.

Averaging up is useful for the following reasons:

  • Your choice has been validated. When the penny stock moves above your purchase price, the upward swing demonstrates that you’re doing a great job of picking investments. Your research and analysis may be rock solid.

  • The penny stock is behaving. Regardless of the reason, the shares are acting like you hoped they would. A stock in motion tends to remain in motion, and as long as the shares are trending higher, averaging up may make sense.

  • Increased visibility. As penny stocks go up in price, they attract more attention from the positive gains. The size of the company also increases, expanding the shareholder base and the number of people invested in them. With this increased visibility, the penny stock may have a long upward run ahead of it.