Keen on averaging in stock market: Evaluate the Strength and Risk Factors

Averaging down refers to purchasing of more shares after the prices falls below the initial purchase price in order to bring down the

Keen on averaging in stock market: Evaluate the Strength and Risk Factors

The relentless fall of the domestic equities in the recent times is nerve-wracking for an investor who were anticipating the 2021 bull run to sustain in 2022 as well. Equity market benchmark S&P BSE Sensex logged 22% gains in 2021 despite the coronavirus-related uncertainty. However, inflation threat and monetary policy normalization reverse the trend and brought in sharp increase in the market volatility in 2022. With the massive correction in the some of the stocks from their high’s investors are tempted to opt for averaging. The article delves more about investment strategy “Averaging” which is largely talked recently.

Averaging refers to buying of additional shares of those companies which the investor already owns. Two types of averaging strategy commonly adopted by investors are: 1) Averaging down and 2) Averaging up

Index data Source: BSE India

Averaging down refers to purchasing of more shares after the prices falls below the initial purchase price in order to bring down the average cost of buying. This is adopted by investors in the bear phase or the volatile market scenario when the stock prices have corrected sharply after the initial purchase. In event of the market recovery, averaging down will help to earn more gains instead of just sticking to the initial investment. This is also called “falling knife” investing.

For instance, an investor bought five shares of Reliance^ at Rs 2,731.85 each on October 19, 2021 and bought additional five shares of Reliance at Rs 2408.70^^ each on July 1, 2022. Additional purchase will bring down the average cost per share to Rs 2570.28. [Rs 13659 (cost of first purchase) + Rs 12043 (cost of second purchase)/10 (total number of shares)].  Typically, such additional purchase is done whenever there are hopes of the sharp jump in the stock prices or the company fundamentals are strong and broader market might be falling owing to intermittent weak domestic and global factors.

^Stock name is mentioned only for the illustrative purpose only.  We are not recommending any stock to the investor
^^Stock price source: Financial website

Averaging up refers to buying more stock of those companies after the market price increases after initial purchase amid stronger conviction on the growth potential of the stock. For instance, given the sharp downfall in the market due to covid-19 in March 2021 investor bought five shares of Reliance at Rs 2003.10 each on March 31, 2021 and given the gradually recovery in the market in May 2021 the investor decided to make additional purchase of five more shares of Reliance at Rs 1959.05 on May 3, 2021. In this way investor brings down the average cost per share to Rs 1981. [10016 (cost of first purchase) + Rs 9795 (cost of second purchase)/10 (total number of shares)].  Averaging up is also known as “pyramiding” This strategy is often adopted by traders of adding more to their existing position after analysing of the technical and fundamental indicators related to stock.

Benefits of averaging will be more for the investors when they are confident about the robust fundamentals of the company because in such cases when the business and market cycle revive the stock will start performing well. Hence, before averaging it is crucial to look at the company’s cash flows, earnings, the business model and the management quality. In simple terms, go for averaging only if there is still strong value proposition offered by the company.

In addition, averaging should be done by those investors who have long term investment horizon. Since amid the volatile market scenario, there are possibilities that the stock may fall further and investors need to hold on to their investment for the long-term horizon.

Before averaging in a stock; beware of the risk factors:

  • Firstly, investors should note that by buying more of the existing stock in anticipation of better performance they are increasing the concentration risk. The overall exposure to a particular stock rises significantly in event of averaging.
  • Other risk includes buying more of the stock that has fallen from the initial price also results in behavioural bias of loss aversion wherein investor is fearful of accepting losses and focus on avoiding the losses by holding the losers. In addition, investor is reluctant to leave a stock given their massive investment in it.
  • Averaging can be risky in case of the lacklustre macro-economic scenario, geopolitical risk, political instability as it can bring in sharp volatility and affect the stocks across market caps. In such cases despite strong fundamentals the stock may not be able perform well.
  • Lastly, averaging calls in for investment of the more amount of money which calls for careful assessment of your risk appetite, income levels, short term goals etc.

Summing up

Averaging is most commonly used investment strategy to mitigate the risk associated with the market volatility. But before averaging investor should do careful analysis of the market scenario, macro-economic environment, company fundamentals which will help to make more gains and loose the least amount possible. Avoid doing averaging on the basis of the tip or rumours. If you are trader don’t forget to keep a strict stop loss and if you are investor, be patient to hold on the investment for the longer term.