“Averaging down” is a common tactic for investors.

The concept is simple.

If a stock you own falls in price, you buy more. As a result, your overall cost basis in that stock falls.

It’s human nature. If you liked a stock at $20, why wouldn’t you buy more at $10?

Plus, averaging down also makes it easier to at least break even down the road.

The Trap of Averaging Down

Beware, though, because it could be a trap. This psychology is why many investors end up with big-time losing stocks that they refuse to sell.

They refuse to acknowledge that they may have been wrong about the stock. Before they know it, they are deep under water and the stock is “too cheap” for them to sell.

Before you average down, you have to understand why a stock fell. Then you have to make a rational assessment whether the stock really is undervalued. Is the market short-sighted? Or was your investment thesis in the stock wrong?

Blindly buying more of a stock you own purely because it became “cheaper” could be a recipe for disaster.

I have made that same mistake myself in my early days of investing. But the truth is, not all stocks that fall come back up! Or if a stock does eventually recover, it could take years. The money you sank into the stock for years could have been invested in another stock that’s actually going up now!

Why Averaging Up Makes Sense

Sometimes, the correct investment decision is to sell our losers and keep—or buy even more—of our winners!

Everyone wants to buy low and sell high, so buying the same stock at a higher price seems to go against human psychology.

Indeed, there are times when a stock rally is fueled purely by pie-in-the-sky speculation. You’ll want to be careful here. Usually a rally not backed by actual improvements in a company isn’t sustainable.

Other times a stock jumps because something has meaningfully and permanently changed in the company’s favor. It could be a brand-new product, a new partnership, management change, or a myriad of other things with lasting impact.

Here, a stock rally is backed by substantial development(s) that permanently improves the outlook for revenue growth and earning potential. Thus, even if you are buying more shares at a higher price than you originally paid, since there’s a very good chance that the stock will continue to rise as the company’s sales and profits grow, you will probably still make a lot of money.

Of course, before you make any decision to average up or down, you need to do your due diligence and see whether the price movement is a market overreaction or if it reflects some underlying fundamental change in your original investment thesis.

Bet on Them When They’re Young

When you invest in young small-cap companies, you are giving yourself the opportunity to invest in what could be the next great company. However, keep in mind that there is a lot of risk inherent in small companies.

Just because a small company appears to offer great products and services on paper doesn’t mean it will succeed. It’s important not to bet the farm on any one company. But the beauty of investing in young companies before they take off is that even if most of them don’t pan out, you just need one success story. One big winner can easily cover all your other speculative losses and then some.

A young small-cap company with a great idea that turns the corner will usually keep growing for a while. This is why averaging up works. If you believed in the young company in the first place, once it proves that you were right, why wouldn’t you buy more?

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Editor’s Note: Our Investing Daily colleague Scott Chan has just explained a time-proven and methodical way to build wealth.

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