The Hindu Business Line : Downside averaging

One of our clients has a typical trading pattern. He identifies a stock and buys the entire quantity on a single day. He buys more of the stock if it is likely to decline subsequently. The logic is simple. As you buy at lower levels, your average cost comes down. This is called downside averaging. We advised the client not to engage in this strategy. The client argued that research reports sometimes recommend `accumulate', which is equivalent to downside averaging. We had to then explain that downside averaging was different. So, what is the difference?

Suppose you decide to buy 1,000 shares of Shree Cement. You are confident that the price will go up from the current level. So, you buy 1,000 shares at Rs 660 per share. The stock later declines to Rs 620 and you buy another 500 shares.

Note that you initially wanted to buy only 1,000 shares.

You ended up buying 500 shares more because you wanted to lower your cost. That is downside averaging.

Accumulation is different. Suppose you expect Shree Cement to go up but you are aware that the stock could also decline to Rs 590 levels. You buy, say, 300 shares to initiate exposure.

Later, as the stock moves down, you buy the balance 700 shares at various price levels. This strategy is termed accumulation.

You spread your risk by purchasing the shares at various price levels. Importantly, you do not allocate more capital just because the stock declines. The additional money you invest in a loss-making position during downside averaging can be instead used to buy some stock that shows signs of moving up.

(The author is Head, Research, Navia Markets)

More Stories on : Stock Markets | Stocks | Simple Economics

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page