Its a wonderful feeling when the stock you just bought goes up. But let’s be real. This does not always happen, infact whenever we buy a share it mostly falls down (if you’ve traded before then you know what I’m talking about).
Imagine a situation where a stock you just bought went down. What to do in this situation?
Let’s say you bought 100 shares of ITC at Rs.300. After some time the price goes down to Rs.280. Therefore the price needs to hit 300 for the break-even point, then everything above 300 is your profit.
But what if, you buy 100 more shares at Rs.280? Your break even would now be Rs.290, after which you would start making money. This process of lowering your average price is called “Averaging Down”.
Now after purchasing stocks there are 2 scenarios. Either the market can go up or down.
Scenario 1 – Price goes up: Wohoo! This is what you wanted. You sell the shares and book your profit. Go ahead and treat yourself today.
Scenario 2 – Price goes down: In this situation you try to reduce your break-even point so that you can start making profits quickly. And in order to get your break-even point lower you average down, not realizing that your position size is increasing. So if the price comes down further by Rs.2, earlier you would have made a loss of Rs.200 now you will take a hit of Rs.600.
The price continues to fall down from 280 to 260 to 230 and you realize you’re majorly stuck in this share. Then you listen to opinions of professionals on TV, newspaper or YouTube and hope they say something positive about the company. This gives you a short term satisfaction that everything is okay and the price should shoot up any moment.
Inevitably the share price keeps going down and you realize most of your portfolio is eroded.
Now will the above situation happen everytime, definitely not. The above situation is quite rare. But the problem here is that one rare situation will erode all the profits you’ve made throughout months or even years of hard work (maybe even your capital).
So in short with “Averaging Down”, you make small profits but HUGE losses.
While writing this article, this case can be seen with people trying to buy Yes Bank whenever it falls down. In the process of buying more and more Yes Bank, they are now realizing that this company has now become the highest weighted share in their portfolio. Hence this concentration has thrown the risk-reward balance out of the window.
Btw if you’re stuck in Yes Bank, that’s okay. Every investor goes through this phase. Just make sure to learn from your mistake and not repeat them in future.
So do you mean “Averaging Down” is never a good strategy?
I never said so. There is only one situation where averaging down works and that is when you’re buying a fund (mutual fund or ETF). An individual company can collapse quickly (Nokia in 2013) but a fund cannot. If a company like Nokia was in that fund then it would be removed and some other company would have taken its place. Therefore averaging down can be a good strategy in a fund.
What strategy to use instead of Averaging Down?
Instead of Averaging down, “Average Up”. This means that we are doing the exact opposite of averaging down.
In Averaging up strategy we sell the shares which have gone down and invest those proceeds in a share that is going up. Here we will incur frequent small losses and rare big profits. This is because you will be buying more and more of a share that is doing well. Your position size will increase in the strong performing share, which will increase your absolute gain on every rupee increment in that share price.
One big profit can create immense wealth for years to come and this is the strategy which was used by Rakesh Jhunjhunwala while buying Titan. As the price went higher he kept on buying more. This started multiplying his profits and made him a famous personality.
The bottom line
Averaging down shares is one of the biggest mistakes beginners do. This one strategy can create a huge dent in your portfolio very quickly. Its good if used in a fund but NOT in an individual share. This is because the share might just keep going down, and may not exist in future.
Ditch Averaging down for Averaging up and soon you’ll find your portfolio growing insanely high.
This was just one of the lessons our students are taught in our online course. Click here to know more about it.