‘Average Down’ or ‘Averaging a stock’ is when you buy additional shares at a lower price, bringing your average cost down.
For example, you buy 10 shares of Reliance Industries for ₹ 1600 per share. A few days later, the price falls and you buy 10 more shares for ₹ 1550. You now have 20 shares of Reliance Industries and the average cost per share is ₹ 1575. This is called ‘averaging’ down.
Does averaging down work?
Over the years, several retail investors have created huge wealth by accumulating shares during market crashes and holding them for a long time. This strategy requires you to have long-term patience, courage to buy more when the price is falling and probably the most important thing – averaging down only established and good quality companies.
But most inexperienced investors tend to buy poor-quality companies and then average down the price. This can lead to disastrous results and permanent loss of invested money.
Negatives of Averaging Stocks
An investor I know lost his entire investment by averaging down a fraud company. He purchased shares of Sintex Plastics when the price was 100. Bought more to ‘average down’ when the price fell to 80. He continued to buy at 60, 50, 30, 20.. and now the price is ₹ 1.2 per share.
Not only is his entire investment lost, but when he first bought the shares at ₹ 100, he only invested ₹ 25,000. To bring his average down, he invested ₹ 70,000 more. Altogether he lost around ₹ 95,000. If he had not averaged down, his loss would only be his initial investment of ₹ 25,000.
That’s the biggest negative of averaging the wrong stock. It can lead to wealth destruction.
Always remember, a stock that falls 90%, can fall 90% more. Sintex Plastics fell from 100 to 10. That was 90% loss in share value. From 10, the stock has further fallen to 1 rupee per share. That’s another 90% loss.
Positives of Averaging Stocks
If you understand a company’s business and have done your fundamental analysis, averaging down can help you buy quality stocks at lower prices. Averaging down has worked well for long-term investors in companies like Britannia, Reliance, Bajaj Finance etc.
Most quality companies with stable businesses fall because of temporary reasons (market cycle, rumours, change in government policies etc). Such falls can be opportunities to buy more shares and average down.
As of January 2020, there is an opportunity to average down in sectors like Auto and Pharma – which have hit multi-year lows. If an investor has long-term investment view of 5-10 years, industry leaders in these sectors could be providing a very good investment opportunity.
Technical Analysis to Average Down
Learning technical analysis can be very helpful even for long term investors. Knowing the right levels to buy stocks, based on chart reading can help you avoid blunders in the stock market.
If you have any questions on averaging down of stocks, kindly post them in the comments section below.