A simple guide to averaging up in the stock market

Developing a good portfolio is tricky. First, select a set of stocks after researching their financials and prior performance. Next, use a variety of technical indicators to confirm they are in line with your goal. After completing all these steps, you will need to rebalance your portfolio at regular intervals. 

Now, the challenge is, how would you enhance the weightage of performing stocks while decreasing your exposure to worthless stocks? The answer is the ‘Average Up‘ approach.

Understanding averaging up in a stock market

Averaging up is a stock market strategy in which you buy additional shares of a stock you already own as its price rises. This approach is based on the belief that the stock’s price will continue to increase, allowing you to capitalise on its momentum.

Here is an example to illustrate how to average up in stocks:

Let’s say you own 100 shares of a company called XYZ at Rs 500 per share. The company does well, and the stock price soars to Rs 600. Seeing the positive trend, you buy another 50 shares at this higher price. Later, as the stock price reaches Rs 700, you buy 30 more shares.

By doing so, your average purchase price increases, and you also increase your investment in a stock, which shows a solid upward trend. 

How to calculate averaging up in the stock market?

Is there any formula to average up stocks? Well, the average price is calculated by adding the total amount spent on the shares and dividing it by the total number of shares owned. Here is how to averaging up stocks.

Continuing with the previous example, the calculation would be:

New Average Price = {(100 × Rs 500) + (50 × Rs 600) + (30 × Rs 700)} ÷ {100 + 50 + 30}

= (Rs 50,000 + Rs 30,000 + Rs 21,000) ÷ 180

= Rs 1,01,000 ÷ 180

= Rs  561.11

Types of averaging up in a stock market

The four different types of averaging up in the stock market are detailed below.

1. Frequency-based averaging 

This is a strategy in which an investor increases their stock holding at regular intervals, regardless of the price. This approach usually applies to systematic investment plans (SIPs) in mutual funds. 

2. Value-based averaging

This is a strategy used in a bullish stock market. Investors buy additional shares of a stock as its price increases, as they are confident in its growth potential. 

For example, an investor initially buys 100 company shares at Rs 1,000 each. As the stock’s price rises to Rs 1,200, he purchases more shares, raising the average cost but also increasing the potential for profit if the stock continues to rise. 

3. Weighted averaging

In this approach, each purchase point is assigned a distinct significance level, unlike simple averaging, which considers all points equally. This approach values specific prices more heavily based on various criteria.

For example, an investor may assign greater importance to the prices on days when trading volume is high or during particular seasons under the assumption that these prices better represent the asset’s actual worth.

4. Exponential averaging

This method stresses newer data, allowing the latest asset prices to impact the calculated average more than earlier prices significantly.

This method is highly beneficial for forecasting stock prices because it enables investors to prioritise recent market trends without disregarding historical price movements. Essentially, it’s designed to track the trajectory and velocity of asset prices.

When to avoid ‘averaging up’ in the stock market?

Three scenarios when you should avoid averaging up in the market are:

1. Bear market

When stock prices fall across the board, it is risky to assume that a stock will rebound because it is cheaper. The market can remain wrong-headed longer than you can remain solvent, and prices can fall further than you expect.

2. Poor fundamentals

If a company’s earnings, management, or industry prospects worsen, buying more shares will only deteriorate your portfolio’s overall returns. 

3. Market bubble 

When speculation rather than solid fundamentals drive prices, they can sink just as quickly as they rose. Averaging up in such a scenario can lead to significant losses if the market corrects.

How to use ‘averaging up’ effectively?

Here is a step-by-step guide on how to use ‘Averaging Up’ effectively:

• Initial research: Conduct thorough research on the stock before averaging up. Ensure that the company’s fundamentals are strong and it has growth potential. Look for consistent revenue growth, profitability, and a competitive edge in the market.

• Investment thesis: Develop a clear investment thesis about why you believe the stock will continue to rise. This could be due to a new product launch, expansion into new markets, or any other catalyst that could increase the stock price.

• Incremental purchases: Instead of buying bulk shares at once, consider making incremental purchases as the stock price rises. This allows you to benefit from the rising market while reducing the risk of a significant investment at a peak price.

• Monitor the trend: Monitor the stock’s performance and the overall market trend. Averaging up works well in a bullish market where the stock is on an upward trajectory.

• Risk management: Be mindful of the risks involved. This approach increases your average cost, which means that if the stock price begins to dip, your losses could be more significant. Set stop-loss orders to shield your investment from significant downturns.

• Portfolio balance: Ensure that averaging up does not lead to an imbalance in your portfolio. Maintaining diversification to mitigate risk is crucial.

• Profit booking: Have a plan for booking profits. Decide in advance the price point at which you will sell the shares to realize gains.

Conclusion

Remember, ‘Averaging Up’ should be used judiciously and as part of a broader investment strategy that matches your financial objectives and risk tolerance. It is a tactic best suited for investors who have a high conviction in the continued success of a stock and are comfortable with the associated risks. To know more, stay tuned to StockGro.

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