Don't Average Down

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I'm annoyed. I invested in Starbucks (Nasdaq: SBUX) a few months ago, because the price seemed attractive, but the stock has tanked since then. I'm down some 37% as I type this. I'm also down 39% on Fuel-Tech (Nasdaq: FTEK), and 26% on General Electric (NYSE: GE). Ouch!

Do I want to sell my shares now? Not really. I still have faith in the companies. I still think that they'll reward me over time. Given this point of view, many investors might urge me to "average down" now -- buying more shares of the stocks, so that my average cost basis drops. 

How averaging down works
Let's say I bought 100 shares of General Electric at $38 each. Simplifying matters a bit and excluding commissions, my cost basis, for tax purposes, would be $38 per share. With the stock recently trading around $28 per share, I'm looking at a $10-per-share loss right now.

Now if I buy 100 more shares, at $28 apiece, I would own a total of 200 shares. Having paid $3,800 for the first 100 and $2,800 for the new shares, I've spent a total of $6,600, for an average price of $33 per share. That's why it's called "averaging down" -- my average price has fallen. So it now looks like I'm only down $5 per share, on average.

You might think that I've improved my situation by doing this, but upon some reflection, I really don't think I have. That's because I think of my first investment as a sunk cost. It's a done deal -- I spent that money, buying those shares at that price.

It depends...
Buying the extra shares can make sense -- or not. If General Electric shares are the most attractive ones I can find, given whatever research I've done, then it can be smart to buy some more. But if some other company's stock looks even more attractive, I'd be better off buying some of those shares. Just because I own some shares of GE bought at a higher price earlier doesn't automatically make GE a more sensible investment.

The most rational way to think about whether to buy more shares is to forget about my first purchase in that stock. It's a sunk cost -- money spent that can't be unspent. Putting those first GE shares out of my mind, I should just look at the universe of possible investments, and choosing the best one -- the one (or ones) most likely to reward me well.

Even if I buy more shares of GE, I shouldn't think of it as averaging down, but instead as simply making an additional investment -- "adding on," maybe.

Tax considerations
If you do buy multiple sets of shares of stock, know that when it comes time to sell, if you want to sell just some of the shares (let's say 100 of your 200), you can't simply average them to arrive at your cost basis. That's right -- the IRS doesn't recognize the term "averaging down" when it comes to your gains and losses in stocks. Learn more about the tax rules for selling part of a stock holding in this Roy Lewis article.

Final thoughts
Here are two last thoughts against averaging down. First, in a sense, by merging your second investment in the stock with your first (at least in your mind), you won't give yourself full credit if the price rises slightly. Instead of thinking that you have a $33 cost basis, why not just think of having a $28 basis and a $38 basis? That way, when the stock rises to, say, $32, you can smile at your 14% gain on your second purchase, instead of seeing all your shares as still being underwater.

And finally, beware -- when a stock keeps falling, sometimes it's doing so for a good reason. Snapping up more shares works out really well when a fallen stock recovers. But it can also be a bad move if the stock never changes direction, or takes ages to turn around. Study a company carefully before rushing for seconds. Some investors jumped into more Krispy Kreme (NYSE: KKD) shares when they dipped from nearly $50 apiece to $40. But then they fell to $30, $20, $10, and got all the way down to nearly $2. Stocks such as Sara Lee (NYSE: SLE), Brunswick (NYSE: BC), and Advanced Micro Devices (NYSE: AMD) have fallen by half or more over the past few years -- enough to cause much pain to investors. Some stocks that look like values are really just value traps.

If you'd like to zero in on some seemingly undervalued stocks, I invite you to check out our Motley Fool Inside Value newsletter. A free trial will give you access to all past issues and all recommendations.