We have heard of averaging down a stock in case it’s price falls significantly below the initial buying price but do you average up your stock? If not, AI strongly recommends you to do it for your top bets.
Averaging up a stock is buying more shares in case stock price moves significantly above initial buying price.
As human beings, we are driven by emotions and tend to bother too much about stocks that are in loss as compared to the once which are in profit. It’s a very normal behavior for all of us but do we know exactly when to average down or average up? Mostly, its driven by our feeling of the day & amount of money in hand rather than based on solid logic. In this article, we will try to understand the benefits of averaging up which is specially important for long term small cap investors.
Benefits of Averaging Up: I will try to explain this with a simple example.
Suppose, you bought 10 shares of a stock priced at ₹10, so you invested ₹100. With time, stock price went up to ₹50 and you are happy to sit on a 5 times profit. You do not buy more shares as it will dilute your average buying price. The stock kept on performing & eventually reached ₹500. In the end, you have 10 shares so an investment of ₹100 becomes ₹5000, a profit of 5000% or 50 times. You feel that you have taken full advantage of this uptrend.
In the second case, you bought more shares when stock hit ₹50, let’s say you invested ₹100 more & got 5 more shares. When it further moved up to ₹100, you purchased 1 more share by investing again ₹100. Finally when share price touches ₹500, you had 16 shares & your ₹300 becomes ₹8000, a profit of 2666% or 26 times. Your average buying price is ₹18.75
In second case, you made lesser profit in terms percentage but in terms of real money it was ₹3000 more, that too at a nominal increase in your average share price (from ₹10 to 18). Had you invested extra money on some new or non performing stock, it was an opportunity loss.
While looking at absolute profit gives a great feeling but it is important to realize your top performing bets & invest more money even if it cuts profit percentage into half. You must do this exercise every year to shift money from poor performing stocks to top performing ones.
As a small cap investor, it will benefit you in many ways:
- Not all small cap stocks will give you multibagger returns but the one which gives will certainly witness long period of uptrend (for few years). You must board such ride with greater stakes for greater returns. Long term positive trends are rare in stock market, if you are lucky to witness, hop on.
- By transferring money from loss making to profit making stocks, you are cutting your losses as well.
- You are betting more on a stock that is winning, it gives you confidence & comfort factor on your investment.
- As seen in the example, you will not compromise average buying price by buying more shares at a higher price (because of lesser number of shares at higher prices)
In this article, we have assumed that the uptrend in a stock price is driven by fundamentals and not on speculations. You should never try to average up on speculation driven rally. Similar logic can be extended on averaging down a stock as well.