In my years of advising clients on sophisticated portfolio strategies, few topics generate as much confusion and potential peril as the use of margin. The concept of “averaging down” a purchase price is a common instinct for investors seeking to lower their breakeven point on a losing position. However, when this strategy is executed within a margin account, it transforms from a simple cost-averaging technique into a high-stakes gamble that amplifies both potential gains and certain risks. It is a financial lever that can build wealth or obliterate it with stunning speed.
Today, I will dissect the mechanics and consequences of averaging a mutual fund’s purchase price using borrowed money. We will move beyond the basic arithmetic to explore the margin-specific risks—maintenance calls, interest costs, and forced liquidation—that fundamentally alter the nature of this common strategy. This is not a guide for the faint of heart; it is a framework for understanding the severe ramifications of using debt to pursue average.
Table of Contents
The Mechanics: How Purchase Price Averaging Works (The Simple View)
The arithmetic of averaging a purchase price is straightforward. It is the process of calculating the weighted average cost per share across all purchases.
The formula is:
\text{Average Cost per Share} = \frac{\text{Total Amount Invested}}{\text{Total Shares Owned}}Example Without Margin:
- Purchase 1: Buy 100 shares at \text{\$50} per share. Total = \text{\$5,000}
- Purchase 2: Buy 100 shares at \text{\$40} per share. Total = \text{\$4,000}
- Total Invested = \text{\$5,000} + \text{\$4,000} = \text{\$9,000}
- Total Shares = 200
- Average Cost = \frac{\text{\$9,000}}{200} = \text{\$45} per share
The investor’s breakeven point has dropped from \text{\$50} to \text{\$45}. The stock only needs to rally to \text{\$45} for the position to be profitable, not back to the original \text{\$50} entry point. This is the intuitive appeal of averaging down.
The Margin Account: Introducing Leverage
A margin account allows you to borrow money from your brokerage to purchase securities, using your existing investments as collateral. The key concepts are:
- Initial Margin Requirement: The percentage of the purchase price you must deposit with your own cash. FINRA requires at least 50% for most stocks and funds, though brokers can require more.
\text{Your Cash Outlay} = \text{Purchase Price} \times \text{Initial Margin \%} - Maintenance Margin Requirement: The minimum equity percentage you must maintain in the account after the purchase. For most mutual funds and stocks, this is 25% (brokers often set it higher, at 30-35%).
- Margin Interest: The interest rate charged on the borrowed money. This is a continuous, compounding cost that accrues daily.
Averaging Down on Margin: A Dangerous Arithmetic
Now, let’s replay the previous example inside a margin account. Assume a 50% initial margin requirement and a 35% maintenance requirement.
Initial Purchase:
- Buy 100 shares of Fund XYZ at \text{\$50}/share. Total cost = \text{\$5,000}.
- Your Cash Outlay: \text{\$5,000} \times 0.50 = \text{\$2,500}
- Amount Borrowed: \text{\$2,500}
- Account Equity:\text{\$5,000} - \text{\$2,500} = \text{\$2,500}="50%"
The Fund Declines to \text{\$40} share:
- Position Value: 100 \times \text{\$40} = \text{\$4,000}
- Amount Borrowed: Still \text{\$2,500} (plus accrued interest)
- Account Equity: \text{\$4,000} - \text{\$2,500} = \text{\$1,500}
- Equity %: \frac{\text{\$1,500}}{\text{\$4,000}} = 37.5\%
The equity is still above the 35% maintenance requirement. The investor is uneasy but not yet in a crisis.
The Decision to Average Down on Margin:
The investor decides to buy another 100 shares at \text{\$40}.
- New Purchase Cost: 100 \times \text{\$40} = \text{\$4,000}
- New Cash Outlay: \text{\$4,000} \times 0.50 = \text{\$2,000}
- New Loan Amount: \text{\$2,000}
- Total Borrowed: \text{\$2,500} + \text{\$2,000} = \text{\$4,500}
- Total Shares: 200
- Total Position Value: 200 \times \text{\$40} = \text{\$8,000}
- Total Account Equity: \text{\$8,000} - \text{\$4,500} = \text{\$3,500}
- New Equity %: \frac{\text{\$3,500}}{\text{\$8,000}} = 43.75\%
- New Average Cost: \frac{\text{\$2,500} + \text{\$2,000}}{\text{200}} = \text{\$22.50} NO.
This is the critical error in thinking. The average cost calculation only includes the investor’s actual cash outlay, not the borrowed funds.
- Total Investor Cash Invested: \text{\$2,500} + \text{\$2,000} = \text{\$4,500}
- Total Shares: 200
- True Average Cost Basis for the Investor: \frac{\text{\$4,500}}{200} = \text{\$22.50} per share
The investor feels they have lowered their breakeven point to \text{\$22.50}. But this is a dangerous illusion. The position must recover to \text{\$45} for the loan to be repaid and the initial capital to be recovered. The leverage has created two different breakeven points: a psychological one and a mathematical one.
The Margin Call: The Strategy’s Fatal Flaw
The catastrophic risk of this strategy is the margin call. If the fund price continues to fall, the equity percentage will drop toward the maintenance requirement.
Let’s assume the fund price now falls to \text{\$30}.
- Total Position Value: 200 \times \text{\$30} = \text{\$6,000}
- Total Loan Value: \text{\$4,500} + accrued interest
- Account Equity: \text{\$6,000} - \text{\$4,500} = \text{\$1,500}
- Equity \%: \frac{\text{\$1,500}}{\text{\$6,000}} = 25\%
If the broker’s maintenance requirement is 35%, the equity is now at 25%. This triggers a margin call. The broker will demand the investor deposit more cash or securities immediately to bring the equity back up to 35%. The amount needed is calculated as:
\text{Required Equity} = \text{\$6,000} \times 0.35 = \text{\$2,100}
\text{Current Equity} = \text{\$1,500}
The investor must deposit \text{\$600} immediately. If they cannot, the broker has the right to liquidate enough of the position to pay down the loan. They will sell shares at \text{\$30}, locking in the losses and defeating the entire purpose of averaging down.
Table: The Impact of Averaging Down on Margin
| Metric | After 1st Purchase | After Price Drop | After Averaging Down | After Further Drop |
|---|---|---|---|---|
| Share Price | $50 | $40 | $40 | $30 |
| Total Shares | 100 | 100 | 200 | 200 |
| Position Value | $5,000 | $4,000 | $8,000 | $6,000 |
| Total Loan | $2,500 | $2,500 | $4,500 | $4,500 |
| Account Equity | $2,500 | $1,500 | $3,500 | $1,500 |
| Equity % | 50% | 37.5% | 43.75% | 25% (MARGIN CALL) |
| Investor’s Avg Cost | $25 | $25 | $22.50 | $22.50 |
The Relentless Drag of Margin Interest
Throughout this process, interest is accruing daily on the borrowed amount. This interest is deducted from the account cash balance or added to the loan amount, increasing the leverage and pushing the equity percentage lower. It is a constant headwind that the investment must overcome just to stand still.
A Safer Alternative: disciplined Averaging Without Margin
The prudent alternative is to use a disciplined, periodic investment plan using only your own capital. Dollar-cost averaging into a position over time, without leverage, smooths out your purchase price without introducing the existential risks of a margin call. You can average down without the threat of being forced to sell at the worst possible moment.
The Final Calculation: Risk Magnification
Averaging a mutual fund’s purchase price within a margin account is not a strategy; it is a speculation. It magnifies the risk of a already risky tactic (catching a falling knife).
While the arithmetic of the average cost appears appealing, it ignores the terrifying mechanics of leverage and forced liquidation. The goal of investing is to compound wealth over the long term. Margin debt introduces a short-term solvency risk that is entirely antithetical to that goal.
My professional advice is unequivocal: averaging down is a high-risk strategy that should be undertaken, if at all, only with idle cash. Using margin to do it is a recipe for disaster. The average cost you achieve will be a hollow victory if the process leads to a margin call and the permanent impairment of your capital. In the pursuit of a better average, do not sacrifice your financial stability.
