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What is Stock Averaging? How Stock Averaging Calculator Works?

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What is Stock Averaging? How Stock Averaging Calculator Works
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Are you a long-term investor in the Indian stock market? If yes, you must read this article to know why stock averaging in the stock market is crucial and how it can help you magnify your gains in the long term.

In the stock market, one of the biggest mistakes most investors make (we assume you would have committed this mistake too) is not adding to the existing stocks you already hold. Multiple factors restrict investors from averaging. For example, you feel that it’s counterintuitive because it goes against the basic investment philosophy – buy low and sell high. Or you feel it is better to sell to limit losses when you see prices going down.

However, there is more to it. Let’s understand how stock averaging works using the stock averaging calculator.

What is Stock Averaging?

Stock averaging is a comprehensive investment strategy, where a stock market investor buys additional units of the stocks they already own.  It is a way to either reduce or increase the average buy price of the stock to lower the impact of stock market volatility and take advantage of future potential gains.

The concept of averaging in the stock market is like dollar-cost averaging, commonly known as SIP in India, which allows investing a fixed sum in a mutual fund scheme at regular intervals. Stock averaging is not about averaging down the price of a loss-making stock, or the stock whose fundamentals have deteriorated significantly.

It’s all about adding stocks of the winning companies with superior financial results, to gain from the potential upside price momentum in the long term.

Types of Stock Averaging

There are three types of stock averaging strategies that season investors recommend using:

Averaging up: The strategy is widely used during the bull market phase, where you continue to buy the stocks of a fundamentally strong company only if you are confident about the continuance of future uptrends. It gradually increases the average price of your stock. For example, suppose you have purchased 100 stocks of Asian Paints at  Rs 1,150, and then systematically added 50 stocks each for the next 4 quarters at Rs 1,315, Rs 1,405, Rs 1,466, and Rs 1,555, taking up the average holding price to Rs 1,340.17 for 300 shares.

After two years, you sold the stocks at Rs 2,615, fetching a total profit of Rs 3,82,450. If you have not averaged up, then your profit would have been just Rs 1,46,500.

Refer to the table below to understand the calculations in a better way:

Scenario 1 - Averaging up
Stock Averaging Calculator
Company Asian Paints
Buy # Buying Price Buying qty Investment
1st Buy 1150 100 115000
2nd Buy 1315 50 65750
3rd Buy 1405 50 70250
4th Buy 1466 50 73300
5th Buy 1555 50 77750
Average Buying price (Rs.) 1340
Total Buying Qantity 300
Total Investment (Rs.) 402050
Selling price after two years (Rs.) 2615
Sold Value (Rs.) 784500
Profit Booked (Rs) 382450

Scenario 2
Company Asian Paints
Buy # Buying Price Buying qty Investment
1st Buy 1150 100 115000
Average Buying price (Rs.) 1150
Total Buying Qantity 100
Total Investment (Rs.) 115000
Selling price after two years (Rs.) 2615
Sold Value (Rs.) 261500
Profit Booked (Rs) 146500

Please Note: The values have been rounded off for ease of understanding.

You can use the stock averaging calculator to easily calculate the average acquisition cost of the stock. The effectiveness of the averaging strategy is all about a matter of judgmental acumen. You must be highly cautious while adding a position, or you could erode the value of your investment.

Averaging down: It’s a bear market averaging strategy, where you capitalize on the falling price of the stock to lower the average holding price of your stock. Suppose, over the next five years, you expect the price of XYZ stock to grow by at least four times (4X) from the current level of Rs. 550, therefore you invested a little over Rs 1 lakh into it.  However, due to extreme volatility, the stock’s price declined in the next three months. Taking advantage of the situation, you added stocks worth Rs. 25,000 twice at Rs. 520.83 and Rs 500 levels, effectively bringing down the average holding price to Rs 536.07.

The table below simplifies the calculation:

Scenario - 1 Averaging down
Stock Averaging Calculator
Company  XYZ
Buy # Buying Price Buying qty Investment
1st Buy 550 182 100100
2nd Buy 520.83 48 25000
3rd Buy 500 50 25000
Average Buying price (Rs.) 536
Total Buying Qantity 280
Total Investment (Rs.) 150100
Your current investment value (Rs.) 150100
Loss (%) 0.00

Scenario - 2
Company  XYZ
Buy # Buying Price Buying qty Investment
1st Buy 550 182 100100
Current Market Price 500
Average Buying price (Rs.) 550
Total Buying Qantity 182
Total Investment (Rs.) 100100
Your current investment value (Rs.) 91000
Loss (%) -9.09

Please Note: The values have been rounded off for ease of understanding.

As you see, had you not averaged down the investments, your loss would be -9.09%.

Stock averaging down also helps you reach the break-even point earlier and improve your returns on investment.

Pyramiding: It’s more like a trading strategy, where you average up at multiple price points based on the bullish trends in technical indicators to profit from the stock’s price momentum. You must be more cautious while executing the pyramiding strategy because a wrong trend assessment can impact your profits substantially.

Click here to get your personalized a portfolio of 20-25 potential multibagger stocks for 2022.

Pros and Cons of Stock Averaging

Averaging down is riskier: Compared to averaging up, the risk associated with averaging down is far greater. There are always three questions that come to mind when the price of the stock falls –should I sell it, buy more at lower levels or hedge my position?

The answer is not easy, but experts suggest finding why the stock’s price is falling or rising before making any move. You should always anchor your decision to average up or down based on the information a company provides, not on the stock’s price movement or unsolicited tips. There is a popular joke around the stock averaging down strategy. “Please ensure that you don’t become the owner of the company”. You’re an intelligent investor if you get the joke.

Concentration risk: It is related to portfolio-level risks compared to fundamental changes in the stock. For example, a normally diversified portfolio should not have more than 20% exposure to a single stock. If your stock exposure goes above the maximum threshold when you are averaging, then you face the risk of stock concentration. Any regulatory change can bring down your portfolio valuation.

Deteriorating macro risks: While it is suggested to add stocks to your portfolio or average your positions when the market is going down, it’s better to avoid when the macro risks are high. For instance, during high inflationary pressure and geopolitical tensions, the stock market may move erratically and become highly volatile.

Averaging stock is an effective strategy to magnify gains in the long term, but investors face a dilemma when to add to the long positions. One of the best ways to address the problem is to add stocks when it corrects. It helps to keep the average holding price low so that you can get superior returns when the momentum in the stock picks up.

Read more: About Research and Ranking

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