In this blog, we are going to talk about one mistake often committed by investors and how this mistake is further compounded over time. As investors, we must be interested in just returns, be it from some popular or from an unpopular company. The averaging down strategy should be limited only for the set of quality companies. Not all the stocks are worthy enough to trust in challenging situations, hence it may be better to exit early even at a loss than hoping for the recovery. You may lose on some other good return generating company waiting for this stock to recover.
Yesterday is not ours to recover but tomorrow is ours to win or lose. That seems like life advice and holds true in terms of investing as well.
Investing doesn’t have a guaranteed outcome irrespective of how long you have been at it. Winning some and losing some is part of the game, and at best an expert would try to improve chances of winning, but he can’t avoid losing some.
In this blog, we are going to talk about one mistake often committed by investors and how this mistake is further compounded over time. This mistake is of committing more to the stock in their portfolio which has fallen instead of selling it; hoping or feeling confident that they were right about the stock and that it would go up and they would more than make up their loss.
Savvy investors’ shortlist stocks with sound investment principles- good quality company, with bright future prospects, a reasonable price at the time of purchase. A bright future might be either a new technology that would change the way of life, a revolutionary business to serve customers better or a disruptive business that would change how business was conducted until today.
But not all seeds sowed turn into trees. The same happens when we invest our capital in a portfolio of stocks. Investing is all about the future and analysts and investors need to make some assumptions about it. No one can be always right. Multiple reasons can lead to a stock not performing as expected, some business reasons, and others beyond it.
Since these events may have a terrible outcome on our investment value, we diversify into a number of stocks due to our inability to forecast the future of an individual company accurately.
Averaging downwards-a strong urge but not always the right thing to do
When it comes to investing, overconfidence causes investors to exaggerate their ability to predict future events. They are quick to use past data and to think they have above average abilities that enable them to predict market movements into the future. A common behavior seen here is averaging down i.e. buying more when the stock price starts falling
Is averaging down a bad thing to do? A simple no, would certainly not qualify for the right answer here. This is because averaging down is effective (only) if the stock eventually rebounds because it has the effect of magnifying gains. But if stock continues to decline, averaging down has the effect of magnifying losses.
There is a behavior typically seen among retail investors where they consider a beaten-down stock as cheap with tremendous upside potential. Is it necessarily true? Of course, it’s not.
When is averaging down likely to benefit you?
As discussed earlier, if the stock eventually rebounds, averaging down can have you magnifying gains. But the million-dollar question is- how do you know if the stock will rebound. There are few companies that have an established track record of consistent growth and good governance often termed as Blue chip or Coffee Can companies. These always trade at a premium valuation and seldom become cheap.
But equity being a volatile avenue causes these companies to correct either due to some company-specific issue or market-wide sell-off as was seen in March 2020. These companies have a rock solid balance sheet and a short term problem is less likely to impact their long term growth prospect.
For e.g. if the CEO of a top Indian IT company resigns citing a personal reason, there is no real reason why the long term growth prospects will suffer. Or a real life example of Nestle that faced issues with its key brand Maggi, allegations on Sun Pharma promoters for related party transactions. Such challenges do not persist for a long period provided the company, brand, management and its talent pool is strong. In such a case, not panicking and staying put or even adding on to your investments makes sense during the fall.
But the important point here is that there are only a handfuls of companies in the market to apply this strategy on. Hence it becomes more important to know when not to do it!
When to avoid averaging down?
In most companies, growth is the main decisive factor for valuation and hence the primary factor to be tracked actively. As soon as the growth starts falling, the companies start losing their premium valuations. Hence getting off the train as soon as you know that the time it will take for you to reach the destination is increasing is a wise thing to do than hoping it will go faster. There are multiple other trains that can take you to your destination at a faster rate even if the ticket is slightly expensive.
Now let’s understand how we can deal with the decline in stock price if there is an issue other than slowing of growth. To simply put it, if the impact of the event is material, then refraining from averaging down is a wise decision. For example, let’s discuss the Yes Bank saga where severe corporate governance issues led to the blow-up of the company. In hindsight, it is easy to point that selling Yes Bank was a very wise decision but at that time, investors hooked on to it hoping that it would reach its 400s level. However, over the period we have all seen the materiality of the issue.
Hence without having a bias or favoritism towards a company, if you see that the impact on the company is material, it is better to get off the boat. There is no point in hoping for the best unless you are running the company yourself.
Rationales have given for averaging down
There is a tendency among investors to refrain from booking a loss and masking this behavior by stating it as a long term investment. The basic premise of any long term investing is a company with durable quality creates wealth and bad quality destroys wealth; so without durable quality, long term returns can’t be anywhere close to expectations.
It is seen that retail investors easily fall in the trap of catching a falling knife. Nitin Kamath, the founder and CEO of Zerodha, in one of his blog post, said that 2 lakh people out of the 7 lakh who have Demat accounts with Zerodha, held Yes Bank stock despite stock falling ~85% over the past year. These clients are collectively sitting on an unrealized loss of over ~60% in the stock. Many of the clients ‘averaged down’ at least 4 different times as the stock fell.
Another 1.25 lakh investors hold Ashok Leyland with a loss of 40% and over 1 lakh people hold Tata Motors with over 51% loss both averaged downwards.
In a nutshell
The averaging down strategy does not work for all the companies. During the fall in stock prices, averaging down should be limited only for the set of quality companies. Since not all the stocks are worthy enough to trust in challenging situations, for the rest of the companies, it may be better to exit early.
As investors, we must be interested in just returns irrespective of which stock helps us earn it. We shouldn’t have any affection towards one particular business or stock. Even if we exit at a loss, whatever we lost in terms of opportunity cost we can earn back from other stock ideas. Prospects can change and hence every time you make a decision, you make it afresh and based on new evidence rather than deciding based your old purchase price or historical ownership of a stock.
One should move out the moment they learn that the financials and narrative are not quite they had assumed it to be. t. Rather than focusing on making up for the loss, protect what is left. Not every trade is going to be profitable, some will disappoint. Instead, make it up from other stocks.
At Moneyworks4me as with other advisors, some calls would not work out as expected and the situation of a stock/company can change for the worse. We expect the subscribers to act at the earliest when a sell call is given. We regularly assess risks in our investments; and upon quantifying if we find them material we consider exiting the stock. If we are fortunate, we may have enough time to exit at a small loss. However, on rare occasions, we may not lead to a steeper cut in stock price before we could exit.
Our portfolio manager can help in this regard as its dashboard doesn’t mention your purchase price or your current return from an individual stock. This helps you reduce your anchoring bias and think independently to do the right thing with the current set of numbers and observations.
We would like to reiterate, “Yesterday is not ours to recover but tomorrow is ours to win or lose.”
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