The strategy of “averaging down” involves investing additional amounts in a financial instrument or asset if it declines significantly in price after the original investment is made.

Say you buy $10,000 face value of a bond at a price of $100 and the price goes down to $90 and you buy $10,000 more. The average cost for your holdings in this bond has now been lowered to $95. Admittedly, this is a simple example, but you get the idea. Repeating this action as the bond price falls will lower your average cost even more. Sounds good, right?

It depends. You could be getting into a bond whose price is poised to sink much, much lower, and that’s a risk no one wants to take – a risk often referred to as “catching the falling knife”.

In fact, there is a radical difference of opinion among investors and traders about the viability of the averaging down strategy. Proponents of the strategy view averaging down as a cost-effective approach to wealth accumulation, but opponents view it as a recipe for disaster. So how does one avoid catching the falling knife?

In order to decide if this is a good method to adopt, you must determine whether the decline in price of the bond being considered for averaging down is due to general market conditions or to a deterioration in the credit dynamics of the issuer of the bond, which could be the precursor to a default.

Making this judgement is no easy feat, but key things to look for include a solid long-term track record, stable business/industry, strong competitive position, manageable-size debt, steady cash flows, positive long-term earnings outlook, and sound management. After research done by you or your advisor, you should hopefully get a feel for whether the drop in the bond’s price is temporary or a sign of trouble.

If you are convinced that management is on the right track, the fundamentals are solid, and you plan to hold the bond for a long time, then averaging down may work to your advantage. You would have acquired a good bond for a bargain, and if the price on the bond makes a comeback you could also benefit from capital gains, which would be “icing on the cake”.

However, it is important to note that a price turnaround is not a necessity for this strategy to work, because even if the price does not improve after you have averaged down, you still benefit from a lower average price and a yield on your holdings in this bond which would be higher than if you had not averaged down.

As I have said before, there is no crystal ball in investing. It all boils down to research, market knowledge, expectations, instinct, and sometimes sheer luck. Averaging down can be a viable investment strategy for bonds, stocks, mutual funds and exchange-traded funds. However, due care must be exercised in deciding which positions to average down.

Toni-Ann Neita is assistant vice president – Personal Financial Planning at Sterling Asset Management. Sterling provides medium to long-term financial advice and investments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm. You may visit us on Facebook or follow us on Twitter, and for more information please visit our website www.sterling.com.jm