The conventional trading wisdom is never to average down a losing position. Don't let hope push you to compound a mistake. When a loss hits a certain point, then cut the stock, take the loss, and move on. But there are some exceptions to the rule.
In general, this is very good advice. Most market players have a natural tendency to add to a weak position. There are a couple of reasons for this. The foremost is that in behavioral economics, it is believed that the pain of a loss produces roughly twice the emotional response than the pleasure of a gain.
We feel losses much more intensely than we feel gains, and that drives us to avoid admitting mistakes. It is less painful to hold on to hope that this stock pick isn't bad and that the market will soon see that we are correct. We hold on to hope and avoid admitting a mistake. Not only do we not take the stop and move to the sidelines, we actually tell ourselves that this is still a great stock and keep buying more.
Most traders suffer their biggest losses because of this tendency to avoid pain. They keep adding to a losing position and then finally give up when the loss is sizable, and pain becomes too great. Discipline and planning go out the window, and emotions drive decision-making.
A blanket prohibition about averaging down a losing position is probably a good idea in most cases. Set a hard stop - Investors Business Daily suggests 8% under your purchase price - and if it hits, then take the loss. You can always rebuy the position and try again, but the stop-out will give you time to make a more objective evaluation.
The problem with this approach is that you often will dump a good position simply because there is elevated volatility. A stop of 8% may be good in some situations but would not be effective for low-priced, very volatile stocks that move that much on a daily basis.
An Alternative
One alternative to the blanket prohibition against averaging down is to plan in advance to build a position with a series of buys. The initial buy is small, and there is plenty of room to buy several more times into subsequent volatility.
When I first buy a stock, I assume that my entry point is suboptimal and that the stock will not go straight up from my entry. I assume that I will have a chance to add to my position at a lower price and keep my buys small enough to take advantage of dips and pullbacks.
The key to this approach is that there still must be a point where you are forced to admit a mistake and take a loss. You can not just keep buying more and more. Position size has to be controlled, and the loss can not be allowed to exceed a certain level. Even if you buy primarily on fundamentals, there is a time when you have to say that maybe my analysis is wrong and this stock isn't cheap, it is a mistake.
Like most things in trading, there are two considerations here - a plan and discipline. If you make a plan and stick with it, then you can pretty much handle everything the market may throw at you. Setting rigid stops and not averaging down a losing position is a very good plan, but there are other ways to approach the situation, but they require advance planning and rigid discipline.
