Final answer:
Dollar-cost averaging involves investing a set amount regularly to reduce volatility's effect on the purchase price, while averaging down involves buying more shares as the price drops to lower the average cost per share. Averaging down can result in poor decisions if the investment's decline reflects underlying issues, unlike dollar-cost averaging which mitigates such risks through diversification.
Step-by-step explanation:
Dollar-cost averaging is an investment strategy where a person invests a fixed amount of money into a particular investment on a regular schedule, regardless of the asset's price. Over time, this strategy can reduce the impact of volatility on the overall purchase. The idea is that by investing the same amount of money each time, you will purchase more shares when the price is low and fewer shares when the price is high, averaging out the cost of your investment.
Averaging down is a different investing strategy where an investor buys more of an investment as the price drops, with the aim of reducing their average cost per share. However, this strategy can lead to poor investment decisions if the asset continues to decline in value, as it may reflect fundamental problems with the company or its market.
The potential pitfalls associated with averaging down include the risk of concentrating too much capital in a losing position, ignoring changing fundamentals, and the emotional challenge of investing additional money into a declining asset. It differs from dollar-cost averaging, which spreads investment risk across time and price levels.
Potential Pitfalls of Averaging Down
- Risk of over-concentration in a single investment
- Ignoring deteriorating fundamentals of the asset
- Emotional difficulty of investing more into a declining position
Diversification, as mentioned in some of the information provided, is essential for managing risk since it can offset some of the risks of individual investments. This approach was especially important during the stock market fluctuations in the first decade of the 2000s and the decline in 2008, which significantly impacted those close to retirement.