Financial markets are the source of wealth for hundreds of traders and investors. The unique aspect of stock markets is that one doesn’t have to follow a set pattern. A number of strategies and patterns can be applied to create wealth through equity investments. One of the basic rules of equity investments is diversification. It is the primary reason why most people invest in a bucket of stocks rather than a single company.
Investment in a bunch of stocks creates a portfolio. The important question is how to increase the weightage of winning stocks in your portfolio and limit exposure to weak companies. If you analyse your portfolio carefully, you are likely to notice that a few companies create the bulk of value while others just languish in the background. Averaging up can be an effective strategy to magnify the impact of the winning stocks on the overall portfolio. To average up stocks, you need to understand the concept of averaging up in stock markets.
What is averaging up?
Averaging up simply means to buy additional shares of a company that you already own at a higher price. It increases the average price of the entire holding. But why would an investor buy additional shares of a stock that he/she already owns? Averaging up is a trend following strategy. By averaging up, investors seek to gain from a prevailing positive trend. If you have a stock that is rising rapidly, averaging up strategy helps in gaining from the positive momentum. Let us understand with an example. Suppose you have 100 shares of XYZ, bought at an average price of Rs 20 per share. The earnings of XYZ are growing well and you expect the share price to inch up. Anyone in such a situation will buy more shares of XYZ. After a few days, you buy 100 shares of XYZ at Rs 30 per share. The share price continues rising. Once again, you buy 100 shares at Rs 40 per share. After the third transaction, the average price of your holding will increase to Rs 30 per share.
Averaging up can be a rewarding strategy in a rising market. Some investors average up based on specific catalysts while others average up based on fundamentals. Many investors start averaging up after a stock crosses a certain price level. Certain investors also take into consideration technical indicators like moving averages and up-down momentum while averaging up.
Benefits of averaging up strategy
Enter winning stocks: There are always some stocks in the portfolio that witness sustained pressure. The price keeps falling and the losses keep mounting. A sustained decline in stock price creates more selling pressure. A simple rule of the markets is that if a stock is declining someone somewhere must have spotted a weakness in the financials or management of the company. Bad stocks are always the first to decline. On the other hand, averaging up in stock markets helps you enter winning counters. If a stock is seeing sustained buying, it means, a large number of investors must be bullish on its prospects. By averaging up, you get an opportunity to gain from the upward movement.
Avoid a trap: Many people buy additional shares when the share price is falling. It helps in lowering the average buying price and increase the potential profits. But by buying a stock on the way down, the chances of catching a falling knife increase significantly. Averaging up is a relatively safer strategy. It helps in avoiding problematic companies.
Brings at the forefront of a rally: All companies start small. When the company is small, the market cap is low and it attracts limited investor attention. As the market cap rises gradually, more investors take notice of the stock and buying increases. As soon as the stock crosses a certain market cap threshold, stock price rallies. Averaging up in stock markets keep you at the forefront of the increase in stock price.
Get a multi-bagger: It is very hard to predict multi-baggers even for highly experienced investors. A stock that has risen two-fold, may witness a price rise of five times in the near future. However, no one can predict if the stock may become a multi-bagger. The only way to increase your position in a potential multi-bagger is to average up at regular intervals. The additional shares bought while averaging up can help one reap rich rewards.
Points to note
While averaging up in stock markets is a popular trend-following strategy, it can also lead to substantial losses if one is not careful. Many people average up when the price of a stock is rising and is expected to rise further. However, the strategy can also backfire. If you average up just before a sharp correction, the losses can be higher. It is always advisable to sell small percentages of the holding to lock in some gains. By selling small percentages, one can insulate his/her portfolio from a steep correction. Another important point to keep in mind is the weightage of the stock that you average up in the portfolio. Averaging up will increase the weightage of a specific stock in the portfolio. If you have set target levels for the portfolio, make sure that the weightage of specific stocks is in line with the set target.
It is important to select the right stocks while investing in equity markets. However, stock selection can never be perfect. There will be winners and losers. The ideal strategy is to increase the probability of winning and averaging up does exactly that.