Cost Averaging- A strategy you should use carefully.

AVERAGING-HOW IT WORKS

You buy 500 shares at Rs 50 per share, but the stock drops to Rs 40 per share. You then buy another 1000 shares at Rs 40 per share, which lowers your average price to Rs 43.33 per share. The idea is to invest more at lower levels and try to bring down your purchase price almost near to the market price so that in the next minor upward movement, you can sell off the stock at a profit.

But before doing that , we need to think about the angle from which you have invested money.Have you invested money in a ‘business’ or is it just another ‘sizzling hot stock’ in the block? The distinction is important.

INVESTING IN A STOCK

If you are investing in a ‘Hot stock’ , you look for buy and sell signals based on a number of indicators. Your goal is to make money on the trade and you have no real interest in the underlying company other than how it might be affected by market, news or economic changes. Once the stock price reaches your expectations –you sell it off and book profits. Averaging is not a good technique when investing in a stock (as opposed to a company) it is always better to cut your losses at 5%. When the stock drops that much, sell and move on to the next deal. In the above example you may sell off the shares at Rs 47.5

INVESTING IN A BUSINESS

If you are investing in a business (as opposed to a stock), you have done your homework and know what’s going on within the firm and its industry. You should know if a drop in the stock’s price is temporary or sign of trouble.

If you truly believe in the business,you should look out for opportunities to average down the cost of investments by buying more shares when ever there is a temporary fall in the price.That way, you can increase your holdings in the company and bring down the cost per share. Accumulating more stock at a lower price makes sense if you plan to hold it for a long period.

This is not a strategy you should employ lightly. If there is a heavy volume of selling against the company, you may want to ask yourself if they know something you don’t. The “they” in this case will almost certainly be mutual funds and institutional investors.

THE RISK INVOLVED IN AVERAGING

The risks associated with using cost averaging investment strategy is when the stock you purchased never goes up. You keep buying more shares at lower levels sinking more money into a stock that can never go up. So you have to do your home work before deciding upon a list of ‘businesses’ you’re going to invest in and employ the cost averaging strategy. For example- there are certain industries where India as a country’s competitive advantage is so strong that buying the shares of companies in that industry on declines is always a good strategy, examples being Pharmaceuticals & Technology.

THE ADVANTAGE

The advantage is that it helps to bring down the average cost substantially. The break even price is low and gains are made more easily. This remains true even if the initial entry price is not reached again.

For example the investor initially opens with 100 shares at Rs 50. The price drops to Rs 40. Then a further 200 shares are bought at Rs 40. So the average cost comes down to Rs 43.33 I.e. the stock doesn’t need to return to the original Rs 50 to breakeven. Consider then, if the uptrend takes off and the price breaks through to Rs 55. As then the risk pays off as the return is Rs 3,500 as opposed to the Rs 500 it would have been without averaging down.

SOME PRACTICAL TIPS

  • Try to average down on those blue chips. These stocks are comparatively safer than those mid-caps and small caps.
  • Never use this technique on small caps.
  • Before averaging down, always re-evaluate the fundamentals
  • Try to understand why the stock price has come down.

CONCLUSION

If you’re investing stocks, averaging down probably doesn’t make any sense. Take a small loss before it becomes a big loss and move on to the next trade.In the above example –you suffer a small loss of Rs 1250 /- and go into the next deal.

If you invest in businesses, averaging down may make sense if you want to accumulate more shares and are convinced the company is fundamentally sound.

You may like these posts:

  1. Initial wealth building strategies – 3
  2. Balancing your investments.
  3. Understanding Average True Range.

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