Averaging Risks

One of the most popular strategies adopted by investors to enhance return on overall investment is averaging. Averaging narrowly means that you purchase a particular stock at different price levels to optimise acquisition cost and enhance returns. Averaging can also be applied to a short position. If you have sold stocks initially or gone short on the stock, you could sell more if the price goes up. But here we are only considering the case of investors purchasing more of a particular stock when price of that stock falls.

There are many reasons for investors being tempted to resort to averaging. First, the average cost of acquisition of total

 

holding in that stock would come down which in turn would enhance returns on a subsequent upturn in price of that stock. Second, the fall in the price may suggest to investors that the stock has bottomed out and become an attractive buy. Third, investor confidence in that stock has come down following the fall in price hence there is urge to break-even and exit the stock.

Though this seems a fool proof way of enhancing returns but the strategy could back fire if bearish sentiment continues in the stock for a substantial duration. For instance, take the case of Himachal Futuristic scrip. You bought ten shares of Himachal Futuristic at Rs 2200. When the stock fell to Rs 1800, you bought ten more shares of that company believing that the stock has already fallen Rs 400 or 22 per cent and would not fall further. You thus brought down your average cost of acquisition to Rs 2000 per share. But, subsequently you were proved wrong and the price plunged to Rs 1200.

Your portfolio of 20 shares incurred a loss of 40 per cent, lower than a 45 per cent loss which you would have made if you had not averaged. But this is little consolation for the loss in absolute terms is Rs 16,000 against Rs 10,000 if you had not resorted to averaging. You would start making profit only when the stock crossed Rs 2000 level, your average cost of 20 shares. Thus, averaging has only created a deeper hole in your pocket because of your larger exposure.

This is not all for there is opportunity cost of additional investment that has to be considered. In others word, if you had invested the additional money in some other stock instead of more of the same stock, you could have perhaps achieved better returns apart from reducing risk through diversification.

Hence, while averaging one has to be very cautious. If the fundamentals of the company have changed or there is any negative news on the company, it may not be a good idea to average. In such a situation you should review your investment and take a position accordingly. On the flip side, if the stock price is falling just on account of bearish sentiment in the market as a whole and the fundamentals of the company have not changed, you could consider further investments provided you are willing to be patient and wait till the market picks up.