Stocks plunged on Monday and have recouped some of their losses today. Given that markets have been able to shrug off corrections and make newer highs, the 'buy-on-dip' strategy has become a big hit with retail investors.
Many retail investors use market corrections to buy more shares of companies they already own in their portfolio, an approach known as averaging. How does averaging work, and when should one average the positions. Let's learn more about it.
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What is averaging in the stock market?
In simple terms, averaging refers to purchasing a set number of shares at different prices over time, helping lower the overall cost of the shares.
What is the fundamental premise behind averaging?
The principle of averaging stems from the understanding that no one can predict market movements. Even the most skilled investors come to realize that consistently buying stocks at their lowest or selling them at their highest is nearly impossible. As a result, it's prudent to distribute investments over time instead of investing a lump sum all at once.
Read: Stocks that bucked the trend yesterday and continue to show strength today
Why is stock selection crucial before considering averaging?
Choosing the right stocks or constructing a portfolio is crucial and should be done before considering averaging or making any purchase decisions. The key is to carefully select the best stocks for investment. After this selection, investors should allocate a portion of their capital to the chosen stocks and make multiple purchases over time, rather than investing all at once. This approach avoids the mistaken belief that one can perfectly time the market and buy at the best price.
How should one approach averaging in stock purchases?
Like a Systematic Investment Plan (SIP) in mutual funds, investors should buy stocks in batches at various price levels. This approach helps secure a more favorable average entry price over time. By making incremental purchases, investors can benefit from market fluctuations, ultimately reducing their overall average cost.
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What is the difference between averaging down and averaging up?
Averaging down is buying additional shares of a stock when its price falls below the original purchase price. This strategy can be beneficial if the stock has solid fundamentals but is temporarily undervalued due to market fluctuations. For instance, if an investor initially buys a stock at Rs 100 and the price drops to Rs 80, buying more at this lower price can reduce the average cost per share to Rs 90.
Averaging up involves purchasing additional shares of a stock that has risen in price. Although it can be psychologically challenging—since it feels like paying more for something that was cheaper before—it can be a sound strategy. This is particularly true when the stock continues to perform well financially and in market terms. Successful investors often increase their holdings in high-performing stocks, thereby enhancing the quality of their portfolio over time.
What are the risks associated with averaging down?
Averaging down can be risky because a stock price decline might indicate underlying issues within the company that aren't immediately obvious. If the market has correctly factored in negative developments, purchasing additional shares could result in greater losses. Sometimes stocks may rise to exorbitant prices, and even when they correct 20 or 30 percent, they may appear cheap relative to their recent highs, but may still be expensive on a price to earning basis.
Therefore, it's essential to understand the reasons behind a stock's decline before deciding to average down. Lacking this clarity could lead investors to make decisions they might later regret.
What are the factors to keep in mind while averaging on the way up?
Averaging up feels like buying something that has become expensive. That need not be the case if the company is able to show consistent growth in earnings. A steady growth in earnings means the earnings per share will increase and even if the market decides to assign the same valuation multiple as before, the price will increase along with the growth in earnings.
If the earnings are not growing and the share price continues to rise, then one needs to be careful while averaging up. But there is also a possibility the market is expecting a big jump in earnings a few quarters down the line, or some favourable change in regulations or some such and valuing the stock at a higher multiple in advance.
Remember, there are multiple factors at play, and one needs to dig deeper before buying more of the stock.
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