What is Stock Averaging? How Stock Averaging Calculator Works?

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 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.

Let’s understand this with the help of an example:

Suppose an investor buys 100 shares of XYZ stock for Rs. 400 per share. His total investment cost is Rs. 40,000. (100 shares x Rs. 400). Due to market correction, the stock price corrects to Rs. 200, and the total value of the investment falls by almost 50%. At this juncture, the investor can either wait for the stock to recover back to previous levels or average his cost by purchasing 100 additional shares for Rs. 20,000 (100 shares x Rs. 200). By averaging, the investor can reduce the cost of his stock holding in that particular share to Rs.300 per share (Rs. 40,000 + Rs. 20,000/200 shares).

When to Consider Stock Averaging

Stock Averaging in the stock market can be done during a bullish and bearish phase. When markets are on the rise, averaging reduces the cost of purchasing additional shares, whereas, during a correction, it reduces the potential loss as the average purchase price decreases.

However, in certain situations averaging in the stock market would not be the ideal thing to do

Stock Averaging is not advisable if a stock’s fundamentals have taken a hit.

When a fundamentally sound stock like Infosys corrects as a part of overall market correction due to bearish sentiments averaging makes sense. Stocks of companies with a well-established business model, good demand for their products/services, low or no debt, high cash reserves, and visionary management are considered fundamentally sound companies. Such companies are usually the first to recover after a bearish phase when the cycle changes.

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Conversely, stock averaging makes no sense when a stock is correcting due to deterioration in its fundamentals. The best examples of such stocks include Jet Airways and Yes Bank, as investors who attempted to average their investments burnt their fingers badly.

Before averaging in the stock market, it is equally important to check if the sector’s fundamentals have changed, resulting in a possible re-rating. For example, in 2019, when the government reduced the duty on electrodes from China, stocks of domestic electrode manufacturers like Graphite and HEG corrected by almost 75%. In such a scenario, when the industry’s fundamentals have taken a hit, it would make no sense for an investor to average his investments in such stocks.

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Avoid averaging in small-cap or trending stocks.

Stocks that become hot favorites of investors overnight due to a sudden policy change or any other reason carry high risk. The same is true with small-cap stocks, which take the highest beating during a market correction. So, it is advisable to avoid averaging in small-cap or trending stocks, no matter how attractive they appear after significant correction.

Maintain a long-term perspective

Averaging in the stock market works best for investors who invest with a long-term perspective. Even fundamentally, stocks may sometimes require adequate time to recover. For investors with a short-term investing horizon, averaging is not advisable.

Check for better investment opportunities

It is essential to consider averaging only if the stock has fallen less than 20%. At the same time, investors should also re-evaluate their risk-return profile and check if any better investment opportunities are available for a lower risk.

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 had not averaged up, your profit would have been just Rs 1,46,500.

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

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

You can use the stock averaging calculator to quickly calculate the average acquisition cost of the stock. The effectiveness of the averaging strategy is all about a matter of critical 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, the stock’s price declined in the next three months due to extreme volatility. 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:

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.

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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 determining 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, an ordinarily 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, 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 them 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.

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