“Don’t invest in something you don’t understand,” said Warren Buffett, who is known to be the world’s greatest investor – and this applies to every investment strategy.
As adults, it is imperative to make informed decisions with your money. Short-term volatility, in most cases, provide buying opportunities wherein you can make a profit. Still, it can also prove to be a source of anxiety and fear. People make ill-advised decisions when they are emotionally overwhelmed.
And that’s where a strategy like averaging down can help plan your profitability in equity trading systematically.
Averaging down strategy
The principle of buying low and selling high rules investment markets. However, a volatile market does not allow an investor always to follow this principle. This scenario is where averaging down helps.
For example, let us assume you invest Rs 5,00,000 to buy 1000 shares at Rs 500 each. You end up losing lose Rs 300 per share if the stock falls to Rs 200. Waiting for the stock to bounce back is the most convenient step. However, this requires you to invest time. But in today’s fast-paced world, time is money. Hence, many investors may decide to invest another Rs 2,00,000, which will provide 1000 additional shares, bringing down the average cost to Rs 350. Thus, the loss is lessened to Rs 150 per share. However, it was made possible due to you investing additional funds. You will lose money if the price continues to fall.
On the other hand, if stock prices rise, you will see a profit when the price reaches Rs 351 instead of the initial Rs 501 required for you to make money. Thus, averaging down helps reduce the amount, but the price of the stock you are betting on must rise for you to make a profit.
Risks associated with averaging down
Falling stock prices can be scary. Evaluating the situation is crucial before averaging down. Suppose the company’s fundamentals are robust and low debt, high cash position, good P/E ratio. In that case, they may be able to bounce back. When this price rises, it will prove to be profitable to those who did not sell.
When everybody is selling, going against the majority has its benefits. However, this might also mean you are overlooking essential aspects that are causing others to sell. Evaluating the past performance of the company and the sector while analysing current scenarios could help decide if averaging down is a good strategy or not.
Conclusion
Each stock has its strengths and weaknesses. Assessing them will guide an investor while investing. While it is difficult for an expert to guarantee returns while averaging down, it can be the best strategy to adopt if the sector and the company you are invested in is facing a momentary setback.
There is no averaging down stock formula where you can enter numbers and predict an outcome. Averaging down stocks comes with its challenges and risks. It is prudent to decide after reviewing all available data points, analyst reports, and predictions.
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