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Equity markets are volatile, with stock prices fluctuating daily. Averaging down can help plan for profitability, but it requires caution. Assess company fundamentals before investing more at lower levels. If robust, the strategy can work wonders, but overlooking red flags can lead to further losses.
This article explains the averaging down concept and discusses its pros and cons to help retail investors make informed decisions. So read on to learn how to utilise averaging down to deal with volatility effectively.
Understanding the averaging down concept
The averaging down strategy involves buying more shares of a stock at lower prices to bring down the average purchase price. This reduces the breakeven point, allowing profits at relatively lower price levels during an upswing.
Let’s understand this better with an example:
Ramesh invests Rs 5 lakhs to purchase 1,000 shares of ABC Ltd. at Rs 500 per share. The stock price then falls to Rs 200. Ramesh’s investment value drops to Rs 2 lakhs, leading to a notional loss of Rs 3 lakhs.
Instead of waiting indefinitely for a recovery, Ramesh invests another Rs 2 lakhs to buy an additional 1,000 shares at Rs 200. Now, Ramesh holds 2,000 shares at an average price of Rs 350 per share.
Earlier, Ramesh required the stock to rise back to Rs 501 to break even. However, after averaging down, the breakeven point is lowered to Rs 351. So if the stock recovers to even Rs 400, Ramesh can book profits.
Key benefits of averaging down
1. Reduces breakeven time
By splitting investment across price points, averaging down reduces breakeven time significantly. One needs to get previous highs immediately.
2. Capitalises on lower valuations
Instead of distress selling, investors can accumulate more shares at attractive valuations for higher gains later.
3. Diversifies risk
Investing at both higher and lower prices diversifies risk across price bands. Some holdings provide gains, while others reduce losses.
4. Instills discipline
Taking informed incremental exposure requires discipline regarding research and value buying. This mindset aids long-term wealth creation.
5. Risks and precautions
While the potential upside seems attractive, averaging down has considerable risks if applied hastily. Here are some key precautions:
6. Assess business fundamentals
The company’s financial health, industry outlook, competitive strengths, and management pedigree – all factors must be thoroughly assessed before buying more. Or losses could magnify further.
7. Analyse previous price trends
Understand what key events or factors led to the fall. Evaluate if they are temporary industry issues or flags regarding the company itself.
8. Allocate capital judiciously
Invest only surplus capital for averaging down. Ensure you have adequate emergency funds for contingencies and other goals.
9. Consider opportunity cost
The money utilised for averaging down could be invested elsewhere for better risk-adjusted returns. Do not get emotionally attached to a stock.
10. Use stop losses
Place stop losses to restrict overall losses if share prices trend lower despite averaging down. Reassess strategy if such limits are breached.
11. Avoid numerous iterations
Buying incessantly without analysing risk parameters can put you in a hole. Re-evaluate the overall portfolio instead of excessive iterations.
Example of averaging down gone wrong
To illustrate a scenario where averaging down backfired, let’s revisit Ramesh’s example:
Ramesh invested Rs 5 lakhs in ABC Ltd. at Rs 500 per share across 1,000 shares. When the price fell to Rs 200, he bought 1,000 more shares, taking his average price to Rs 350.
However, ABC continued to fall and touched Rs 100 due to a company scandal. Distressed, Ramesh invested Rs 2 lakhs more to purchase 2,000 shares at Rs 100 apiece.
Now, Ramesh’s total investment was Rs 9 lakhs for an overall holding of 4,000 ABC shares at an average of Rs 225 per share.
The company’s fortunes deteriorated further, and its stock price plunged to Rs 50. Despite all his averaging down efforts, Ramesh stares at a loss of Rs 6 lakhs.
Had Ramesh analysed ABC’s decline reasons, management track record, etc., he could have had limited losses or invested elsewhere. But repetitive averaging down sans due diligence proved costly.
Tips for effective application
Here are some key tips for judiciously applying the averaging down strategy:
1. Limit averaging down to high conviction picks
The company must have robust credentials and a proven pedigree before committing additional capital. Avoid averaging down in speculative small caps.
2. Scale exposure in a disciplined manner
Allocate only 20-25% of the desired position size at the existing price. Add in similar tranches at subsequent lower levels.
3. Avoid fixating on breaking
Once initial research validates business strength, invest because the stock price reflects value, not desperation to recover losses.
4. Book profits incrementally
On uptrends, do not wait to recover the original price. Book profits in phases to capture the upside.
5. Track news flows and quarterly results
Stay updated on key developments, management commentary, and results analysis to assess if the logic for ownership still holds.
6. Maintain a stock review framework
Revisit risk parameters, market conditions, and opportunity cost periodically as part of a structured stock review process.
7. Employ strict stop losses
Draw a line for accumulated losses where you will exit the stock and redeploy capital elsewhere. Define this limit before investing the first rupee.
Conclusion
Investors can use volatility to their advantage by “averaging down” and buying more of a stock as its price goes down. However, this should be done with caution. Consider your research ability, risk tolerance, and investment goals. If you believe in a company’s long-term prospects, averaging down can increase profits. But there is always a risk of losing money. Stay informed and conduct due diligence before implementing this strategy.
FAQs
Dual-class shares refer to a company having two or more classes of common shares with unequal voting rights. Typically, one class is offered to company insiders like founders and executives with superior voting rights. The other class is offered to public shareholders with inferior rights. The goal is to allow insiders to control decision-making while still accessing public capital.
Companies adopt dual-class shares to allow founders and executives to execute their long-term vision without interference from public shareholders who prioritise short-term financial interests. It also acts as an anti-takeover provision. With concentrated voting power, insiders can prevent hostile takeovers by acquirers.
Critics argue that dual-class shares excessively insulate management from accountability and oversight. With unchecked power, insiders can enrich themselves by selling overvalued stock while average investors bear the risk. It also poses succession risks when indispensable founders disengage. Critics want tighter regulation of such structures to protect shareholder rights.
Dual share offerings have become very common, especially among US tech firms. Nearly 20% of listed US firms had dual-class shares by 2018. The trend is also catching up in Asia-Pacific markets, with exchanges in Hong Kong and Singapore permitting such listings after initial resistance. Their prevalence continues to fuel the debate on appropriate checks and balances.
Instead of outright bans, advocates propose measured checks like maximum tenure, higher insider ownership, independent board committees, classified boards with subsets of differential voting rights, and stringent transparency requirements. The goal is to balance innovation benefits with reasonable accountability to minority shareholders.
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