Averaging up a small cap? How to avoid potential losses in search of more returns

reduce lossAveraging up a stock is an excellent strategy for gaining greater returns (in monetary sense) on already performing stocks. After all, if you own a stock which has gone up 50%, there is a temptation to invest more if future looks promising. While this line of thinking is perfectly fine but its execution has to be carefully planned. If this is not planned carefully, it takes just one lower circuit to put you back in loss. In this article, we will give an example with a real stock (Can Fin Homes) and also we will advise the best possible strategy to average up carefully.  

People average up a stock when they see an opportunity to get more gains in terms of money with a stock already in profit. If they don’t increase investment then no matter how much stock runs up, their return in terms of percentage will be high but in terms of money, it won’t be substantial. For example, If you get 10 times return on initial investment of  ₹ 10,000, it will only become ₹ 1 Lakh. However if you had averaged up in same stock and invested overall ₹ 1 Lakh & get only 4 times return, it would have been ₹ 4 Lakhs. So while averaging up is must for high conviction stocks, it must be handled with care. To explain in detail, I have a story of two investors, Mr. X & Mr. Y. Both are fans of averaging up a stock for big returns in terms of money.

In case of Mr. X, he invested in Can Fin Homes when it was around ₹ 1200 during mid of 2016. The stock had secular up-trend and future looked bright. After 6 months, stock was at ₹ 1800 & he was at 50% profit. Sensing opportunity, Mr X increased his exposure & put another investment at stock price of ₹ 1800. After new investment, his average purchase price went up from ₹ 1200 to ₹ 1500 and he was still sitting at gains of 20%.

Can Fin home buy buy.PNG

Then came Nov 2016 in which the stock went into a tailspin and dropped from ₹ 1860 to ₹ 1250 in a matter of 10 trading days. It was helped by a lower circuit of -20% on Nov 15th, 2016. Mr X who was at healthy profit of +20% must had felt trapped at loss of around -20%. What went wrong?

Can Fin home shock

Coming to Mr. Y, who was also tracking Can Fin Homes & invested in similar pattern as Mr X (i.e. invested at ₹ 1200 and sitting on gains of +50%). Sensing an opportunity, Mr Y thought of averaging up this stock but he had a method. He checked if his average purchase price after additional purchase can suffer corrections or not. Mr Y had developed a method based on 3 consecutive lower circuit scenario. As per his method, if stock price crashes, he should be able to pull off his money with profit & there should be a cushion to allow stock prices to recover if such fall is only temporary.

According to this method if a stock has to suffer from three successive lower circuits of -20%, -20% & -5%, it will fall -65% in total. Last one is -5% as circuit gets revised after two successive lower circuits. Mr. Y also looked at history if this had ever happened in stock market & he discovered that 3 consecutive lower circuits is rare for a good quality stock. Of course it keeps on happening on Bhangaar stocks but Mr Y does not invest in Bhangaar stocks, so this strategy can work for him. (Bhangaar stocks are stocks with very less liquidity, priced at less than ₹ 10 & usually a market capital of two digit crores). So applying this method, Mr Y did not invest at 50% profit but he waited till stock price would go up at a point where his post investment returns would remain at +65% at least (shockproof from 3 lower circuits). Since Can Fin was a quality stock, such moment arrived within next 4 months when stock price went up to ₹ 2200-2500 range. In fact, it went up until ₹ 3200 before settling down at ₹ 2800.

So margin of safety applies even when averaging up a stock & it depends on your investment style & preference. You can devise your own method by adding one more lower circuit or reducing a lower circuit. But we at AI feel that 3 lower circuit method is good enough since it does not push your next investment target price too far away.

To arrive at -65% loss protection, you need to calculate new average purchase price as follows. You can use calculator or excel to arrive at your target price before investing more but this effort will be worth doing.

New Average Purchase Price = Total Investment (Old+New) / Total Number of Shares (Old+New)

We are trying to build a calculator for our readers which is based on similar principles. Calculator can be used for building a portfolio of even pure small caps while taking less risks. The Calculator is undergoing some testing before we can share it with you on AI post. Possibly in next couple of weeks, Stay Tuned!

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