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Thursday, September 2, 2010

Is it a good strategy to ‘average down’ when the price of a stock starts to fall?

The short answer is ‘NO’. Many small investors lose money by trying to ‘average down’ when the price of a stock, which they bought at higher levels, start to fall. How do I know? By the emails I receive from readers and the questions I hear on business TV channels.

Here is a recent email:’I bought Bartronics at an average price of 138. Now it is falling. What should I do?’ Reading between the lines, one can guess that the investor bought at a higher level than 138 and bought more as the price fell, to ‘average down’.

I wrote two posts on Bartronics – first in Jun ‘09 when the stock closed at 165 and the second in Mar ‘10 when the stock closed at 150. On both occasions, investors were advised to get out before it was too late, because the fundamentals of the company were poor. So, I referred the investor to my earlier posts.

The response was: ‘Thanks, I’ll sell Bartronics tomorrow at whatever price I can get, and reinvest in Punj Lloyd or Suzlon.’ I wrote back immediately that both those stocks should be avoided like the plague!

Why? Instead of providing 1000 words of explanation, I’ll take recourse to some pictures:

Downtrend_Bartronics_Sep0110

The Bartronics stock tried a brief recovery above the 200 day EMA on decent volumes in Jul ‘10 – setting up a perfect bull trap. The subsequent waterfall-like drop has taken the index well below the 200 day and 50 day EMAs on increasing volumes.

Downtrend_PunjL_Sep0110

The Punj Lloyd stock went briefly above the 200 day EMA back in Jan ‘10, and has since been in a steady decline well below the 200 day EMA – making lower tops and bottoms. Volumes have been higher on down days. Signs of stocks going from stronger to weaker hands.

Downtrend_Suzlon_Sep0110

The Suzlon stock also went above the 200 day EMA in Jan ‘10, and has since fallen continuously – well below the 200 day EMA. Even if you are enamoured by wind energy, stay away from this bag of wind.

Note that while the Sensex has been making new highs for the past year in a bull market, all three stocks are in bear markets, with no end to their bottoms in sight. ‘Averaging down’ on such stocks can only lead to increasing your losses.

As a contrast, here are some other pictures:

Uptrend_Akzo_Sep0110

After a long sideways consolidation, the Akzo Nobel (former ICI India) stock has had a huge upward break out.

Uptrend_ASAL_Sep0110

Automotive Stampings is a small-cap auto ancilliary from the house of Tatas that was rising steadily before a sharp break out on strong volumes.

Uptrend_TataMotors_Sep0110

After making a loss and languishing due to the debt burden of the Jaguar-Land Rover acquisition, the Tata Motors stock has comfortably out-performed the Sensex over the past year.

I am not suggesting that you buy these stocks right away. It is better to be cautious when a stock is near a 52 week high. But here are a couple of thumb rules that can be easily followed by novice investors:

1. When a stock is moving up above a rising 200 day EMA, it is in a bull market. The strategy should be to buy the dips. That means ‘averaging up’. Use a trailing stop-loss to protect your profits.

2. When a stock is moving down below a falling 200 day EMA, it is in a bear market. You don’t make money in a bear market by buying, but by selling. The strategy should be to sell on every rise.

If you can buy the shares back at the next bottom and sell on the following rise, you can make a ton of money. But such a strategy – known as ‘short-selling’  - is not advised for inexperienced investors.

Related Post

Some do's and don'ts about Cost Averaging

3 comments:

Eswar Santhosh said...

I always resort to averaging down. When I am looking to enter a stock, I buy a lot when I feel it's a decent enough price. Then, I keep adding on falls in lots until I reach my target # of shares or max. capital I planned to invest. I have even made money averaging stocks bought @ 120 prior to crash till 40 (VIP Industries). But, I was (extremely?) lucky in that case, I guess ;)

Jasi said...

Hello Sir!
Very good post indeed.
I guess there are always two parts to buying a share. One, why to buy, which is answered using fundamentals. Two, when to buy, which is answered using technicals.
Im guessing your three points are more about when to buy and not about what to buy.
By the way can you take a practical example and explain averaging up a bit more? We all know how to average down I guess ;) its easier na!

Thanks as always!
Jasi

Subhankar said...

@Eswar: You chose a good stock. The 'lucky' part was the stock rising so high - which was unforeseen.

It is a safer bet to be patient, let a stock find a bottom, make the first high in a new bull phase, and catch it when it recovers from the first correction, as it goes above the 200 day EMA. Then keep buying at subsequent dips. It isn't that difficult once you do it a few times.

I reiterate my thumb rule - buy on dips in a bull market and sell on rises in a bear market. You will never lose money doing that, if you set stop-losses to protect your profits.

@Jasi: OK - but this is going to be a lengthy one, and we will take Eswar's stock VIP Ind. as the example. Look at the chart in icharts.in:

On Apr 15, '09 - high of 53 above 200 EMA; Apr 29 - low of 39 below 200 EMA; May 19 - 51 above 200 EMA - BUY 100 shares for 5K

Jun 3 - high of 67; Jul 13 - low of 41 below 200 EMA; Jul 23 - high of 51 above 200 EMA - BUY 100 shares for 5K

Sep 14 - high of 162 - SELL 50 shares for 8K (reducing holding cost of 150 balance shares to 2K)

Nov 4 - low of 116 below 50 EMA - BUY 50 shares for 6K

Nov 27 - low of 124 - BUY 50 shares for 6.5K. Now you have 250 shares for 14.5K.

Feb 17, '10 - high of 294 - SELL 50 shares for 14.5K. Holding cost of your balance 200 shares has become zero.

Maintain trailing stop-losses and keep riding the bull.