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:

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.

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.

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:

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

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.

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.

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