When to average down the cost and when not to
Many investors ask their investment advisors whether they should average down the cost of shares they have bought when the price of the stock is going down. The logic behind averaging down the cost is that when they buy more shares at a lower price, the average cost of acquisition of the shares declines, so when the stock price rebounds, they can make good profit.
Let us understand how averaging down works by an example. Satish, an avid stock market investor, bought 100 shares of company XYZ at Rs 100 per share, so the total amount invested was Rs 10,000. After two days, the price of XYZ declines to Rs 98 and Satish bought 100 more shares of XYZ, which cost him Rs 9,800. A week later, the price of XYZ further declines to Rs 95 and Satish bought 100 more shares at Rs 9,500. The total cost of all the 300 shares bought by Satish amounted to Rs 29,300, so the average cost of 300 shares of XYZ has gone down from Rs 100 to Rs 97.67 per share.
Now, if the price of XYZ had declined due to temporary sell-off in the market or due to technical reasons, the stock price would rebound if the temporary blip in the market passes away or when the stock reaches the oversold zone. So, if the share price rebounds from Rs 95 as per Satish’s expectation and once again reaches Rs 100, he would earn a profit of Rs 2.33 per share, i.e. Rs 700 on his total investment of Rs 29,300 in 300 shares. So, by averaging down, Satish has managed to turn around his initial losses into profits.
But what if the share price of XYZ continues to slide further down to Rs 93 and then to Rs 90 in a matter of, say, one month? Should Satish keep buying more of the same stock to bring down further the cost of his acquisition? In such a scenario, it is absolutely necessary to understand the reasons behind the decline in the price of this share. If the price is going down due to fundamental reasons such as difficult business environment leading to declining sales and profitability or due to management issues, it would be suicidal to keep buying this stock just to average down the cost of acquisition as it would amount to placing multiple bets on a losing horse. Contrary to Satish’s expectation, the share price may not rebound in the near future and he would be saddled with mounting losses if the share price continues to tank further.
Come to think of it, the reasoning of averaging down is logical enough. But one needs to understand whether the reasons behind the decline in price are technical or fundamental before deciding on whether or not to average down the cost. If the reasons are purely technical, one can average down the cost by buying more at lower prices; however, if the reasons are fundamental, it is always better to book the loss and exit the stock for good.