Tuesday, December 22, 2009

Some do's and don'ts about Cost Averaging

One of the most common problems that many investors face is whether to sell or to resort to cost averaging when the price of a stock, or the NAV of a mutual fund, drops just after a purchase is made.

A typical question I face goes something like this: "I bought a stock at 80, and when it dropped to 40 I bought some more to bring my average cost price down to 60. Now the stock has dropped below 30. Should I sell to reduce further losses, or buy some more to bring the average cost down further, or just hold on till I get back my average cost price of 60?"

There are no easy answers to such a question. The answers will depend on the type of stock, the investor's risk tolerance and holding period. So, instead of providing answers, let me try to list out some do's and don'ts that can better prepare investors to face a similar situation.

Do's about Cost Averaging

  1. Before you pick any stock or fund, do a due-diligence. Find out as much as you can about the track record of the promoter or fund manager and the performance of the stock or fund through bull and bear periods
  2. Learn the rudiments of reading a price chart, or at the very least find out about the 52 week high and low values of the stock/fund; try to buy at, or near, a 52 week low
  3. Decide whether you will indulge in short-term trading or long-term investing
  4. Accordingly, set either a tight stop-loss or a wider stop-loss
  5. If the stop-loss is hit, be ruthless about selling the stock/fund
  6. If steps 4 and 5 are followed, the need for cost averaging won't arise if the price falls after purchase
  7. If the price rises after purchase and you are convinced about the future of the stock/fund, buy more. In other words, average your cost upwards.

Don'ts about Cost Averaging

  1. Don't ever buy a stock/fund just because a friend or colleague or TV analyst has suggested a 'buy'; learn to take responsibility and decide for yourself
  2. Don't buy a stock/fund trading at or near a 52 week high
  3. Don't be overconfident of your stock-picking skills just because you've tasted a few successes; always remember to set a stop-loss - whether you wish to trade or invest
  4. Don't become a long-term investor by default because your trade failed and the loss became too large, and you hesitated about selling at your stop-loss
  5. Never cost average downwards, as a general rule and particularly for mid-cap/small-cap stocks/funds (which tend to fall the most during bear markets)

Please remember that your cost price is known only to you. The market doesn't care two hoots about whether you are making a loss or a profit. So you need to develop an investment style that can minimise loss and maximise profit.

A related problem, though not quite as nerve-wracking, is when the price of a stock (or the NAV of a mutual fund) which hardly moves up or down for a prolonged period starts to move up as soon as an investor gets rid of it!

This problem is quite easily solved if you learn the art of partial profit booking.

Related Posts

How to lose less with a Stop-Loss
About Cost averaging and Value averaging strategies

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