When markets are going nowhere?

The averaging down strategy works best, especially in a choppy market.

Burnt investors often disgustedly refer to the stock market as a casino. Indeed, equity investment and gambling have much in common. Certainly, mindsets of successful investors resemble that of successful gamblers.

In games of chance, the odds and payoffs are known and return expectation can be exactly calculated. Take the classic example of roulette. An European roulette wheel has 37 numbered slots, 18 red, 18 black, and a zero. Bets are placed on colour or number. The ball rolls till it stops in a slot. A winning number bet has 35x return. A “colour” bet has 1x return. The probability of winning a number bet is 1/37 and of winning a colour is 18/37. The expected return on a series of colour bets is minus 2.7 per cent.

Risk:reward and expectancies are fuzzier with financial assets. But the thought processes are similar. Above all, any investment strategy like any gambling system must be geared to handle losers.

Successful gamblers never stake all on a single bet. Most keep individual bets in the range of 1-5 per cent of total corpus. Some betting systems involve increasing stakes when winning. Others involve increasing stakes when losing. Good gamblers always keep a stop-loss – a point where they will cut losses and quit.

This is comparable to portfolio diversification, pyramiding (averaging up), and averaging down. Pyramiding is used by long-term investors and traders alike. Warren Buffett has bought stocks like Coke several times, despite price appreciation. The average cost of acquisition rises in a pyramid strategy. But the price rise validates the original “buy” decision. Valuations can even drop while price rises, if the earnings growth outruns price appreciation.

Averaging down is also easily understood. It lowers cost of acquisition during a downturn. The danger is that averaging down may throw good money after bad if the original buy decision was wrong. This is especially true in single stock investments where the company can go bust.

Averaging up or down are especially interesting with a focus on mutual funds and systematic investment plans. The risk of long-term loss with a SIP in an index fund, or in a well-diversified equity mutual, is low. If the NAV rises in a bull-run, should monthly commitment be increased? If the NAV falls in a bear-market; should commitment be increased?

Averaging up is a momentum play. It increases exposure to winning assets. But it creates higher average prices. A stop loss is essential with pyramiding strategies. The investor must always be prepared to book to avoid being left with very expensive holdings.

Averaging down carries two caveats. First, the portfolio must be genuinely well-diversified and capable of long-term recovery. Second, the investor should be prepared to average down systematically over long time periods.

Gambling “negative progressive betting” systems can be adopted. For example, the investor could increase monthly SIP commitment by 5 per cent if the market drops 10 per cent. Therefore, if it drops 50 percent, the SIP commitment increases 25 per cent. Over a long bear-run, such a system reduces the cost of acquisition more sharply. More aggressive commitment ratios (say 1 per cent more in the SIP for every 1 per cent fall in NAV) or logarithmic ratios, which increase as NAV falls, would exaggerate the effect.

In theory, averaging down is impeccable. It cannot be fully implemented in gambling because casinos have maximum betting limits. It's an aggressive tactic. Asset allocation becomes increasingly overweight in equity during downtrends, with resources being moved out of other financial assets like debt. Since bear markets can last a long time, it requires nerves and patience.

Neither system would have made a practical difference in the choppy markets we've seen so far in 2010. Back-testing through full bull-bear cycles, either system can outscore a standard SIP, if the parameters are optimised. The averaging down strategy seems more robust. It works across a wider range of market fluctuations and a wider range of commitment ratios. .

An under-explored area is the application of such methods to specific sectors. Most industries are cyclical. Some are covered by sector funds; in other cases, a basket consisting of the three or five largest players can be created. Here too, averaging down seems a robust strategy though the risks are higher than with diversified equity funds. This could be one approach to investing in depressed sectors like cement, shipping and real estate.