It would be wonderful if every stock you bought immediately went up, but in the real world, unfortunately, that's not the way it usually works. When stocks drop, many investors like to "average down," or add more shares to their positions at the lower price.

Under the right circumstances, averaging down can be a smart long-term investment strategy. But when used incorrectly, it can lead to excessive risk exposure. Here's a rundown of how averaging down works, when it could be a good idea to buy more shares at a discount, and when averaging down should be avoided altogether.

Sale signs in a store's window.

Image source: Getty Images.

What does it mean to average down?

In a nutshell, averaging down means adding to a losing stock position in order to reduce your average share price. For example, let's say that you buy 100 shares of a certain stock for $50 per share, for an initial investment of $5,000.

If the share price falls to $40 over the next month, you could buy another 100 shares at that new price. Now you own 200 shares and have invested $9,000, for a lower average per-share cost of $45.

Going a step further, we'll say that the entire market plunges and your stock falls to just $30 per share. If you then buy another 200 shares for $6,000, you'll own 400 shares altogether at a total cost of $15,000 -- an average price per share of $37.50.

Investment

Shares Bought

Price Per Share

Total Shares Owned

Average Price

Investment 1

100

$50.00

100

$50.00

Investment 2

100

$40.00

200

$45.00

Investment 3

200

$30.00

400

$37.50

To sum it up, the main advantage to averaging down is that you'll have a lower cost basis per share. In our example, if the stock rebounds to $40, you'll make money. But if you hadn't averaged down and had just held your original 100-share investment, a rebound to $40 would still leave you down $10 a share.

The main disadvantage of averaging down is increased risk. Obviously, investing $15,000, as in our example, means that your portfolio's performance depends far more on this one stock than if you had just invested $5,000.

Reasons you should average down

Of course, the goal is to not even have the option of averaging down on your positions. In a perfect world, you'd buy a stock, and it would go straight up. But when a stock moves in the wrong direction, averaging down can be a good option -- in the right circumstances.

The general concept you need to know is that averaging down can be a smart idea if and only if your original reason for buying the stock still applies -- that is, there's no permanent change to your long-term investment thesis.

One good reason to consider averaging down is if a company misses quarterly estimates and the stock goes down. A good real-world example is Apple's plunge in mid-2016 due to a revenue decline and the first-ever annual drop in iPhone sales. The stock fell from about $120 in late 2015 to about $95 after the company's second-quarter earnings report in April 2016. The key point is that short-term headwinds were dragging on the stock, not any fundamental change in the business.

Overall market weakness could be another good reason. If the entire market takes a dive and pushes your stock prices down with it, it could be a good idea to buy even more of your favorite long-term investments at a discount.

Reasons to leave your investment alone, or even cash out

As I mentioned earlier, one big downside of averaging down is increased risk. Think about it: By averaging down, you're increasing the size of your investment. So, if that investment continues to fall even further, your losses can become even greater than if you had left your investment alone.

With that in mind, there are two main situations when I would avoid averaging down on an investment.

The first is when my investment in that particular stock is already a large one. As a personal example, the largest stock investment in my portfolio is currently AT&T. Although I believe the company has a very bright future, and I love its generous dividend yield, I wouldn't be comfortable adding more money to it even if it fell, simply because it would then account for too much of my portfolio. In fact, I already averaged down in AT&T recently, and have reached my limit in regard to how much I'd like to own. My own rule of thumb is that I don't like more than 10% of my stock portfolio in any one company under any circumstances, and my AT&T investment is not far from that.

The second scenario in which I won't average down is if the price fell because something fundamentally changed with the company. In my Apple example, weak iPhone sales in one quarter were not a thesis-altering development. On the other hand, if a competitor were to start taking market share from Apple and created margin-eroding pricing pressure, it would be a different story.

The bottom line

Averaging down on stock positions that have declined can certainly be a smart investment strategy -- under the right circumstances. If you still perceive the stock as a long-term winner and buying more wouldn't make your position uncomfortably large, a decline could be an excellent opportunity to buy more shares on sale. Just be aware that averaging down on a stock position significantly increases your downside risk in addition to your upside potential, so invest accordingly.

Matthew Frankel, CFP® owns shares of Apple and AT&T. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.