Averaging in the stock market means buying more shares when the share price of a particular stock is going up or down.
When we buy more shares when the share price is increasing it called averaging up and when the share price is going down on a decreasing it is called averaging down.
Averaging should be done by investors who have good experience in the market understands the fundamentals of the particular business. Also, investors who are investing for the first time and if the investment horizon is the long term and there is a market crash for example COVID-19 crash or the 2008 crash he can average down his positions.
The most important factor in order to take this decision of averaging in the stock market is understanding the fundamentals of the business.
Whether the business has high cash flows, lower debt, competitive advantage, or an asset which the market doesn’t have an idea about, etc…If the investor is sure about all these parameters he should average down his position or average up his position.
In this article, we will be covering the following topics.
1. What is averaging down?
Averaging down means buying more shares of a particular company share price is decreasing. this is mostly done during a bear face of the market where the market sentiment, in general, is very low. but the fundamental of the particular company is still intact and will provide a greater return over a longer duration of time.
But this should be done only by investors who have good experience in the market or who have the fundamental knowledge about the business model and the financials of the company.
An example is given by Peter Lynch in one of his speeches about Kaiser industries.
Kaiser industries at the time were trading at $26 which went down to $16 and at $14 hid investment company brought the largest block of share at the time on the New York stock exchange, but the share price kept on going down, it reached $10, then $5 and then $3., but he knew the company has many assets in the form of stake in subsidiary companies like Kaiser aluminum, Kaiser steel, Kaiser cement, Kaiser broadcast, etc…
In the end, the parent company distributed shares to the public shareholders of the subsidiary companies which worked out to be $50 a share. But the most important point is knowing the fundamental of the company whose share is falling.
Averaging down mathematically case is very advantages to investors for example if a stock was trading at 100 and invest on had brought 100 shares at that price and then it fell down to 50 an investor more 100 shares now the average share price is 75 ((100*100)+(50*100)/200).
The fall from hundred 100 to 50 was 50% but the rise from $50 to $100 will be $100 percent that’s how maths work.
Average down also being down the break-even point of the particular positions. In the above example, by average down stock to the break-even point have come down $75 which percent translates to 33.33% instead of 50%.
Averaging down can also lead to a human bias called the anchoring effect. where a person buys an At a particular share price and gets anchored to it.
For example, if you buy by a share of a company at 18 and it keeps on falling to 60 then 40 then 20 but in your mind, you have anchored yourself that the share is still worth 60 according to the old president but the present circumstances can be different, so be aware of this bias.
To learn more about mental bias and heuristic you can read the book summary of Stock to Riches Book.
2. What is averaging up?
Averaging up means buy shares of a company when the share price going up words or increasing. This is usually done by investors during the bull face of the market When there is only positive news about the fundamental of the company and positive sentiment in the market.
Doing this only during the bull market is not wrong but the investor should know about the fundamentals of the company and most importantly they should not buy because the share price is going up it can be harmful to the financial health of a person.
This is also good for investors who have a regular income and cannot invest a lump sum amount at a single point of time for example a salaried person can identify a couple of stocks and invest in them regularly over a period of time same like a SIP.
Same as the mathematical case in averaging down, averaging up can provide the same advantage to an investor. If person A buys 100 shares at 10 and person B buys the same amount and quantity, but when the share price moved up from 10 to 20 the person buys another 100 shares.
After a period of time, the share price has reached 3, now the average price in the case of person A is 15 ((100*10)+(100*20)/200) and the gain is 3000 which double the invested amount. But in the case of person B, the percentage gain is triple the total profits id only 2000 (100*20).
The anchoring bias is also true when averaging up. when the bear phase of the market ends and the bull phase of the market starts, people are usually still hooked to the last market high.
Investors think that the market will again fall and they will again buy later which may not be the case. So the investors should look at the fundamentals of the companies instead of the share prices to take their investment decisions.
3. Why average down or up a position?
Investors should only average up or down when they are confident about the fundamentals of the company.
You can also average down a position when there is a temporary problem with the company, for example, because of the problem with the Maggi the share price of Nestle Ltd went down which was a temporary problem but after the product was relaunched the share price went back to its original levels.
Another example is when the Bajaj group started exiting Force Motors because of some promoter issues with Firodia Group, because of this selling the share price fell & this was seen in a negative light by other investors which pressed the stock to go down more.
At this level ace investor, Porinju Veliyath started buying in the company at the price levels of ₹125, because he knew about the fundamentals of the company, and the fight between the promoters. Later on, the promotor group of Force Motors i.e. Firodia Group also brought a significant stake in the company. After few years the share price reached the level of 2000.
There were many more examples related to a temporary problem with companies seen in the market over the years.
But many a time these temporary problems can also turn into permanent problems so an investor should not invest in a particular amount or a percentage of the overall portfolio into a single stock.
4. Magnifying losses
Averaging in the stock market can also cause magnifying losses. An investor should always be aware of the fundamentals of the business and the industry in which the particular companies operate.
Also when the temporary problems turn into permanent problems the survival of the company can be a big question, in this case, an investor should exit the position as soon as possible.
For example, in the case of RCOM, the share price kept on going down, an investor who had kept on averaging down would have suffered a great loss because their temporary problem turned out to be a permanent problem.
In the case of averaging up when the bull market is going in full swing, the share price generally moves up faster and goes from the reasonable valuation to the overvalued category, at such times investors should be aware of the fundamentals and the valuation of the companies in which they are investing.
As the saying goes “what goes up comes down at a faster pace”, this can be especially true if the fundamentals not supporting the more in the share price.
To learn more go to thebalance.com.
5. Conclusion of averaging in the stock market
- Averaging should be done only when you are aware of the fundamentals of the company.
- Be aware of the anchoring bias which can be particularly fatal to the financial well-being.
- Investors should not invest beyond a particular amount or percentage of the overall portfolio according to his or her risk profile in a single stock.
- Averaging should only be should by investors who have a long-term investment horizon.
As Benjamin Graham said,
“In the short term, the market is like a voting machine, but in the long term it is like a weighing machine.”
I (financialwizardindia.com) am not a SEBI registered investment advisor. This article is for information purposes any scheme or company name mentioned here is just for example & not a recommendation.