Don’t average down and compound your problems

One thing that confounds me about the current market sentiment is that the market fall itself is only 20% or so, which is a lot less than the one we witnessed in the last crash but the panic seems to be at least as much as the last time.

One reason for that is the people who “play” the market generally invest in mid – caps, smaller caps, penny stocks and other momentum stocks, which have obviously fallen a lot more than the broader indices.

The two common reactions to such falls are either booking losses, and shunning the market completely, or to average down your purchase by buying more of the same stock.

Both of them are bad ideas, but averaging down on penny stocks or companies with bad fundamentals is worse than shunning the market altogether because you are throwing good money after bad.

I’ve always been wary of averaging because most of the times it becomes a good excuse to hide losses, and I think this is especially true if you hold a penny stock, or some other lesser known small cap that has fallen quite dramatically.

Ultimately, you want to invest in whatever you feel will grow the most from this point onwards and not what has fallen the most already!

This is another one of those easy to say – hard to do things, and I’m fully aware of how difficult it is to actually execute because I’ve faced it myself.

I think a big part of getting over this feeling is to acknowledge that you will make mistakes in picking your stocks like everyone else, and get on with it.

Some people take these losses personally, and their ego hurts, but they overlook the fact that everyone makes mistakes and gets it wrong some of the times. You won’t find examples of mistakes among your friends and relatives because they don’t like to talk about it, but if you look at the portfolio of any active mutual fund – you will find stocks that haven’t performed well, and that clearly shows that even professionals make mistakes.

If you start from a position where you say to yourself – you are going to be wrong in some of these calls – it’s a lot easier to deal with it after such an event occurs.

If you find yourself in the situation I described above, this is also a good time to assess whether in fact it makes more sense for you to invest in diversified mutual funds rather than taking stock positions directly.

9 thoughts on “Don’t average down and compound your problems”

  1. I have never understood why people take direct stock positions. The lure of the market can be a possible reason but generally retail investors do not have the ability of differentiating between a Infosys or a Satyam.
    Most of them lose money in the market but as you rightly say, they only talk about their winners.
    History says that the amount of money you can make via mutual funds (the boring way) is equal or more to the amount of money you can make via direct stocks (the more risky adrenaline rush way as I term it). One is better off spending time elsewhere than looking at the ticker on a daily basis.

    Your article is again a gentle reminder to all retail investors that most of them need to stay in the market longer via safe investment avenues. Most of them won’t heed because if history is any form of picking up lessons, most of us would have done that by now.

    In fact, this is the time to get out to stocks and plough in more money in MFs systematically.

  2. Apt reminder for people to weed out their losses as there is panic. Yes these are difficult times for market and like in gardening we need to weed out the losses. But it is easier said than done for human beings are not rational.
    Behavioral finance talks about loss aversion as to why we refuse to sell a loss making investment. If our investment turns out to be good, we are happy to sell and feel good about the gains. However, booking a loss is painful, so we tend to postpone the regret we feel at having made the wrong decision. We choose to wait out, ignore, or worse, add more to a poorly performing investment, hoping to average out the cost. Therefore, cleaning up a portfolio is a tough task and calls for rational decision-making

    Investing in stock market takes lot of knowledge, time and energy and it is suggested to invest in Mutual Funds. But I would like to stress that Investing in MFs is not a sure shot formula and one needs to weed out the badly performing MFs too For example, those who are still holding the JM Basic Fund bought in 2007 in the hope that they will recoup the loss, should liquidate. Or those who invested in SBI Contra Fund or Reliance Growth Fund, highly recommended funds few years back, should switch to other MFs.

    Bottom Line is investment in stock market or equity MFs needs to be tracked. We just can’t buy it and forget it.

  3. I feel averaging down should be done on a selective basis.
    Pre-requisite: Review of the fundamentals of the stock, reason for the drop in the stock value, willingness to hold for a longer time.
    For example, the rise in interest rates is expected to affect the financial sector. So most PSU banks are available below their BV, with an impressive EPS. I did invest in a few of them a month back and now they are even more cheaper. I am comfortable in averaging down on them. On the contrary, a few other stocks dipped suddenly and I tried averaging down and burnt my fingers. I am being cautious now and I use the following guidelines:
    1.Is it a good stock in a bad sector (“bad sector” according to market mood) or a bad stock in a good sector – if it is the former, averaging down is worth the risk. If it is the latter, you are in for trouble.
    2.Is it a “Buy” on an advertising website/ technical analyst or is it being bought by Mutual funds – if it is the former, it is a likely disaster and if it is a latter, it is worth the risk. I usually compare the percentage holding in the last two months by credible funds that own the stock. Be wary of the index funds and arbitrage funds, though – numbers may be misleading.
    3.Do you believe in averaging down alone or either averaging down and up – I believe you should stick to either one. If you do both, you don’t benefit much, as the fluctuations and your averaging up will dilute the benefit of averaging down.
    I did not give examples as I was not sure if that is permitted.

      1. Thanks, Manshu.
        Examples for “Good stock in a bad sector” – I would go for banks like Allahabad Bank in PSU or for that matter even Dena Bank. I bought them at 160 and 80 per share respectively and I won’t mind averaging down now. Agreed the NPA is going up but if you look at the “moat” of PSU banks among the common man, they will consistently make profit. Take Engineering sector, for example. Several compaines, even zero debt companies like Voltamp transformers, are available at impressive valuations. You may have to wait for sometime for them to grow but it is well worth it. Example for the corrolary – IFCI LEAF etc – if you try averaging down, you may reach a bottomless pit. Similarly over valued stocks like VIP. If one tries averaging down now, it is asking for trouble.
        Stocks like Kirloskar Ferrous Industries, CESC, Biocon etc are quietly accummulated by Mutual Funds and DIIs but not many advisors talk about stocks with good fundamentals. They advise based on technicals – which only enables traders to make money from the ill informed investor overvaluing a stock on one side and a panicking investor undervaluing it on another.
        Regarding both averaging down and up – usually when a stock is oversold, if you have been sequentially averaging down, there will be a short covering by sellers. For example, if you look at the trend of Shree Renuka Sugar mills last week, it was dropping from 55 to 32. Then it momentarily went up to 35. If you would have thought the bottom is reached at 32 and it has started going up, you are mistaken, since it was due to short covering by traders who oversold the stock. It has continued its southward journey again. Worth waiting till this trend resumes and then average down, provided you are convinced of the fundamentals of a stock. Otherwise you would have been buying at the same time as a desperate trader who has oversold and made his profit already, losing a bit of it for shortcovering when you will be losing your hard earned money.

        1. Good examples and I agree that you can always find great value picks even in these uncertain times. Quoting a dialogue from Wall Street:Money never sleeps Bulls make money, Bears make money it is the pigs that get slaughtered
          One who knows what is happening and reasons behind it can make take calculated risks and average down. But what it one does not know or doesn’t want to know..then ? Just don’t average down for the heck of it…we all hate losses..but then we do hate taxes too and pay them. At times cutting your losses makes more sense and we should be astute enough to realize it. We need to be fully aware of what we are doing..which takes time and discipline.

        2. The thing that I am guided by is can I get another company cheaper than this one at the current price and that’s it. Ultimately you want to see what the best option is at this point in time and nothing else in my opinion.

          Trying to find good stocks in bad sectors and that kind of thing is fine, but why not just sticking to finding good stocks!

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