Busting the Common Myths about Investing (II)

This blog is the continuation of "Busting The Common Myths about Investing" where we will further discuss the common investing myths.

Averaging down always works

Previously, we had revealed the truth behind the myth: High risk leads to high returns, in the prevailing blog we'll throw lights on the tenacious myth about averaging down. So let’s start over;

Averaging down is buying a stock, watching its price drop, and then buying more shares so that the average buy price can come down. In short, it refers to buying stocks when their price dips. Averaging down is similar to the childhood riddle,

“Betty bought some butter. But the butter was bitter. So, Betty bought some more butter to make the bitter butter better.”

As an investor, you must have heard this idea from several people. If you buy a stock and its price declines, then buy more. As when you buy cheaper, the average cost declines, but this doesn't reduce the loss of the investor.

For instance: - Raj purchases 500 stocks for ₹100 of a company with the total cost of (500 x 100) ₹50,000. After some time, the stock price decreases to ₹80. Raj purchases additional 500 stocks of worth (500 x 80) ₹40,000 so that the average price of the acquisition comes lower than ₹100. As a result, Raj was at a loss of ₹10,000, and now he has put 40,000 more for reducing the average buy price, but the loss of ₹10,000 stays the same.

So, previously Raj had a loss of 10%, and in the second case, he suffered a loss of 11.11%.

Hence, at last, the total loss is the same, bringing the average price of acquisition down, when trying to reduce the loss in terms of percentage.

The big assumption in averaging down is that the stock at some point will increase in price, but if they don’t, the investor will regret the day he traded in such stocks.

Let’s look at the example of a Federal bank; a pioneer in the banking sector of India.

In 2017, the stocks of the federal bank showed a reverse movement from the usual trading pattern.

The stocks failed to generate momentum and witnessed the sale of securities. The stocks broke its 50-day line on November 17, 2017, and hit a stop-loss mark of 8% resulting in the market sell-off.

Since then, the stock has corrected by a shocking 18%. If one had bought the shares on every dip, then eventually it must have led to a loss for the investors.

Since then, the stock has corrected by a shocking 18%. If one had bought the shares on every dip, then eventually it must have led to a loss for the investors.

Averaging down does not necessarily generate high returns

Averaging down does not necessarily generate high returns and when stocks are dipping, averaging down is like lending money to your childhood friend who keeps asking for money but never pays back.

This time he comes up with an urgent reason for lending money, and you confer with him, despite knowing that getting your money back is uncertain.

Averaging down strategy is commonly preferred by investors, investing in a long-term investment plan. It is best when stocks increase in value because it has the effect of boosting gains.

Averaging down is best with blue-chip stocks having an excellent reputation, solid cash flows, and an exceptional track record with minimal debt.

On the other hand, if stock continues to decline, averaging down has the effect of surging losses and at the time of dips averaging down claims to be a loser’s game.

Before averaging down a company's fundamentals should thoroughly be assessed. When the stock price decreases, the losses can escalate, manifesting that averaging down doesn’t work every time.

Therefore, it’s significant for investors to correctly assess the risk profile of the stock that has averaged down.

At last, investing myths can be a dampener. They can hold the investor back in achieving his set objectives. Moreover, other kinds of myths are elaborated in the next article.

Continue reading the next part, click here to redirect.