Should you average the stock price by purchasing more?

Most investors adhere to the investing principle, "buy low and sell high." However, stock market volatility sometimes makes it difficult to make investing decisions. Averaging is a trading strategy that helps deal with the sharp ups and downs in the stock market.

What is the average price?

We all learned the concept of average in school. If you buy four items at Rs. 40, Rs. 50, Rs. 70, and Rs. 80, respectively, your average buying price is Rs. 60. Average price refers to the total value divided by the number of items.

In the stock market, you can calculate the average price of shares to identify your cost of purchase of each share. Buying more shares when the price falls below the purchase price is a good idea since it reduces the holding cost. Before you press that button, you must understand the difference between simple average and weighted average, though.

To calculate the average price in the stock market, you must always prefer a weighted average instead of a simple average. If you only look at a simple average to estimate the average price in the share market, you can eventually incur losses instead of earning a profit.

Let us understand this with the help of an illustration.

Amit buys 100 shares of a company at Rs. 200. The total spend is Rs. 20,000. The price of the stock falls to Rs. 160 next week. Amit incurs a loss of Rs. 40 per share. Now, Amit has two options. He can either wait for the stock's price to increase or invest Rs. 24,000 more to buy 150 shares.

If he does the latter, the calculation of weighted average stock price is as follows:

Total invested amount = Rs. 44,000 (Rs. 20,000 + Rs. 24,000)

Total number of shares = 100 + 150

Average stock price = Rs. 176

Many investors use the simple average method:

Total purchase price = Rs. 360 (Rs. 200 + Rs. 160)

Total number of transactions = 2

Average stock price = Rs. 180

There isn't a significant difference between the simple average and the weighted average in the example. But, when you trade in larger volumes with higher volatility in prices, use weighted average price to determine your cost of purchase.

Also Read: How to identify momentum stocks?

How to use averaging to your benefit?

Averaging can work in both rising and falling markets. If you purchase stocks in rising markets, averaging helps to accumulate more profits. Similarly, in falling markets, it helps in reducing the average purchase price.

Here are some conditions to consider before purchasing more stocks to average the stock price:

1.  Reason for a falling stock price

Averaging works best when the fundamentals of a company have not worsened, but the performance of its stock is impacted by industry-specific conditions or poor market sentiment.

2.  Potential of the company

Sometimes, the stock of a company with good potential is under pressure. As a result, it leads to a fall in prices. The chances of averaging helping you, in this case, are high. An investor should look at the quality of the management, the balance sheets, and other valuation parameter of such companies to make averaging fruitful.

3.  Averaging in rising prices

Many investors prefer to do the averaging when the stock prices are rising. They think that stock price will increase further and it’s a good time to accumulate more shares. However, the average cost price will increase in this strategy. This strategy brings good profit if the stock price continues to rise.

Last words

To sum up, averaging is a common strategy used in stock trading, wherein the investor scales up or scales down on the share price to diminish the effects of market volatility. There are several ways by which one can average prices. You can choose the average up, average down, or pyramid strategy. In the pyramid strategy, the trader keeps buying the stock at multiple price points. However, averaging is a high-risk strategy ideal for seasoned traders, which may bring losses if the stock price fails to recover.