Is Averaging in Stocks Really a Good Strategy?
Namaste, this blog will help you to make your investing more profitable by using a technique called averaging. This blog mainly focuses on how to do averaging to get more returns. Let’s take a quick recap of what we will cover in this blog. Let’s start.
What you need to know before jumping in
- What is averaging in stock market and how to do it
- what is the correct amount required to get your portfolio positive
- In which sector you should invest or diversify your portfolio
- How to pick the correct stock from specific sector
- What is correct time for doing your average. let’s begin with first point
What No One Tells You About Stock Averages
What is average ? This term we have discussed in our schooling it is nothing but summation of the required numbers divided by total number of quantity for example average of two numbers 100 and 200 is 150 how it is derived just adding the number and divide by their quantity that is 2. The same principle is applicable on share also we have to add the purchase price of shares and divide it by total quantities we got in number of orders.
Definition: Averaging in the stock market involves buying more shares of a stock over time, regardless of its price. This strategy potentially reduces the overall average cost per share. For example, if you initially buy a stock at a high price and later the price falls, buying additional shares at the lower price reduces your average cost per share.
How Market Fluctuations Change the Power of Averaging
Now take a scenario where you buy a stock for 1000 rupees and the stock price is continuously falling down by 10% and you want to average it so at what price you should average at every 10% fall down price to get your investment positive.
If you choose to invest rupees 500 for every 10% falling price that is at 90% at 80% at 70% and so on. You add to rupees 500 on every 10% falling price what is your portfolio is the stock price is fall 30% and you average rupees 500 every 10% falling price surprisingly your portfolio is 50% in loss it is because you are averaging 500 rupees which is 50% of your initial investment that is rupees 1000
So what we conclude from this is that if you want a break even we have to average at least with the same amount of initial investment. Take the previous scenario if in place of rupees 500 if we are investing 1000 rupees on every 10% fall in price your portfolio at 30% fall in price will actually at break even that is no loss no profit
Ultimately, if you want a profit, you need to average at a higher price than your initial investment. For instance, you can decide on a target profit percentage and average it on falling prices accordingly. If your initial investment is 1000, you may choose to invest 1100 at a 10% drop, 1200 at 20%, and so on. This makes your portfolio profitable.
Now the question arises, Which stock are best, which sector is good for investing and so on. Also, how much initial investment required if we choose averaging method or how much funds are needed and many other related questions.
So firstly, I want to answer which stock you should pick for averaging purpose the answer is quite simple but required intensive knowledge yes I am talking about the most and commonly term fundamentally strong stocks and if you want to know how to do, how to read the fundamentals of any company you can visit our previous blog where we have discussed in detail what are the steps required for fundamental analysis. But in brief, here are the three important steps in fundamental analysis, first analysing various ratios, second analysing growth of the company and the third analysing sector and related peer competitor companies.
Now it’s time to answer the second question which sector to be picked for averaging purposes. You have two choices: either pick an emerging sector or pick a current high demanding sector where there is a high potential of employment and growth. It can be manufacturing or space technology or infrastructure, energy, pharma, agriculture etc. Choose on which sector country is focusing majorly, on which sector investments are increasing etc. Analyse such things and you will find the perfect sector for your investment and of course averaging.
The next step after finalizing your sector is to finalize the perfect stock for your investment for this you have to follow again the same rule of fundamental analysis if you want to diversify your portfolio then choose at least 3 to 4 different sectors and in that sector finalize minimum 5 best stocks based on their market capitalisation their growth their profitability etc and rank them based on criteria as mentioned and you get the right stock to invest
The Truth About Using Averages to Pick Stocks
Now, let’s understand some key points about averaging. Remember that averaging only applies when stocks do not perform as predicted. Only average stocks that are fundamentally strong. You should have more than your initial investment amount available, as you may need to average continuously if the stock falls. Hence, it is essential to have a significant amount of capital for averaging purposes, about 9 to 10 times your initial capital. If your goal is averaging, do not invest a large capital initially, as you will require more funds for averaging if the stock does not perform well.
The Real Story Behind Averaging and Making Money
But again I repeat only average those stocks which are fundamentally strong and have great potential of growth but due to certain circumference stock price falls in that scenario only you can apply the averaging technique. and try to understand what is the intrinsic value of any shares using discounted cash flow method or dividend discount method. In the next blog we will cover the best way to easily understand the intrinsic value of any share.