When markets corrected significantly few weeks back, first time investor Rajesh Jha was in a fix. Some of the stocks in which he had invested recently fell by around 25-30% turning his total investment of 3 lakhs to roughly 2.10 lakhs.
Clueless about what to do next, Rajesh sought advice from his friend Vijay who was a seasoned investor with several decades of experience in the stock markets.
Vijay advised him to simply average his investments as the outlook of market looked positive in the near term. As Rajesh was not sure about how to proceed further, he took some detailed instructions from Vijay and went on to average his investments. As the markets recovered soon, it proved to be a right decision.
Like Rajesh there are many investors, especially new ones who are not sure about ‘What is averaging in stock markets.
In this article let’s take a detailed look at ‘What is averaging in stock markets’ and when it makes sense.
The basic principle of wealth creation from stock markets is \’buying at a low price and selling at a high price\’. But it is not as easy as it seems. Stock market volatility makes it very difficult to buy low and sell at high prices.
An effective way to manage the impact of stock market fluctuations on your portfolio is by averaging in the stock market.
In simple words averaging in the stock market means purchasing more quantity if the stock falls below the purchase price so that the average cost decreases.
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 cost of investment is Rs. 40,000. (100 shares x Rs. 400). Now due to market correction the stock price corrects to Rs. 200, the total value of investment has fallen 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).
Averaging in stock market can be done during a bullish phase as well as a bearish phase. When markets are on the rise, averaging reduces the cost of purchasing additional shares, whereas during a correctional phase 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.
Averaging in the stock market 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 debt, high cash reserves and visionary management are considered as fundamentally sound companies. Such companies are usually the first to recover after a bearish phase when the cycle changes. Click here to invest in 20-25 fundamentally sound multibagger stocks chosen after detailed research.
On other hand when a stock is correcting due to deterioration in its fundamentals it makes no sense.
Best examples of such stocks include stocks like Jet Airways and Yes Bank as investors who attempted to average their investments ended up burning their fingers badly.
Before averaging in the stock market, it is equally important to check if the fundamentals of the sector have changed resulting in a possible re-rating. For example, in 2019 when 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 fundamentals of the industry itself have taken a hit; it would make no sense for an investor to average his investments in such stocks.
Avoid averaging in small-cap stocks or trending stocks
Stocks which become hot favourite of investors overnight due to a sudden policy change or any other reason carry high risk. Same is the case with small-cap stocks which take the highest beating during a correction phase of a market. Hence it is advisable to avoid averaging in small-cap stocks 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 at times require adequate time for recovery. For investors with a short-term investing horizon, averaging is not advisable.
Check if any better investment opportunities are available
It is important 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 any better investment opportunities are available for a lower risk.
Market fluctuations are inevitable part of an investment journey. By averaging their investments wisely, smart investors can gain immensely provided the averaging is done only fundamentally sound stocks and that too with a long-term perspective.