Averaging down means buying more of a stock as its price falls, aiming to lower the average cost. This is done to reduce the weighted average cost of capital (WACC). On the other hand, pyramiding involves adding to a position as prices rise, also known as averaging up. The key is to start a position, make incremental purchases in a downtrend (averaging down), or in an uptrend (averaging up) until a set limit or a maximum investment is reached.
However, many people make the mistake of averaging down when prices are falling, going against the trend. It's crucial to follow the trend, as the saying goes, "the trend is your friend." Buying when prices are decreasing increases the risk of losses because there's no certainty that the price will turn around. Instead, it's better to buy when prices are increasing, following the trend, even if it goes against the notion of buying low and selling high.
People often fear buying stocks when prices are rising due to the fear of a potential fall. However, buying high and selling higher can be a successful strategy. The key is not to trade against the trend. Pyramiding works well in a trending market, but identifying the right points to add to a position can be challenging.
Averaging down can lead to greater profits in certain circumstances, but it's essential to distinguish between a stock's individual event and a broader market correction. For this strategy to work, the company should have good performance, minimal debt, and a growing cash flow.
Ultimately, once in a trade, if it moves in your favor, the probability of success is higher, while immediate movement against you increases the likelihood of failure.
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