Is averaging a smart or irrational strategy?

imgbd MasterMind is a joint initiative between Sundaram Mutual and Wealth Forum, in which we offer insights into how you can become a more effective advisor to your clients, by understanding them better, understanding how they think, understanding how they take financial decisions. This gateway into your clients' minds we believe will help you relate better to them, communicate more effectively with them and thus serve them better. Mastering your client's mind is your gateway to becoming a more successful advisor. Its not for nothing that they say, "Its all in the mind!"

In previous articles in this series, we have discussed how right brain emotional impulses often come in the way of rational investing and how "Loss Aversion" makes investors hold on to losing positions irrationally (Click Here to access previous articles in this series). In this article, we will build further on these insights to explore why averaging down is so popular with investors. Is averaging just another emotional response to seeing a loss or is it a smart investing strategy? Read on to understand when averaging makes sense and when probably it doesn't.

Your client bought 1000 shares of company A at Rs.100 per share. Two months later, the stock's price is down to Rs.70. His first impulse is to buy another 1000 shares at Rs. 70 and bring down his average price to Rs.85 per share. As his advisor, what would you say? Is this a smart strategy or is it an irrational strategy? The answer really lies in what went on in the client's mind when making this decision to average down.

Averaging could be an extension of loss aversion

We saw in the previous articles on loss aversion (Click Here to access previous articles in this series) why investors are often very reluctant to book losses and how the human mind instinctively looks for a reason to convert despair into hope and thus shut out the painful thought of a loss. This is what makes investors nurse losses for years - the hope that the investments will recover one day in value and come back to cost, thus avoiding the need to take the pain of booking a loss. When the mind is looking for ways to convert despair into hope, averaging presents a wonderful opportunity to do just this.

Let's go back to our example. Your client is now sitting on a loss of Rs.30 per share. He obviously wants to hope that the share price will rebound and go back above 100, but perhaps somewhere in the back of his mind, he realizes that a 30% drop is quite a lot to recoup and may not be that easy. But, if he were to average down and buy a further 1000 shares at 70, his average holding price instantly comes down from Rs.100 to Rs.85. Now, the gap between his holding price and the market price has halved from Rs.30 to just Rs.15. The way his mind would probably think is that surely, the stock can move up by Rs.15 in the next rally, giving him the exit he is so desperately hoping for. His decision to average down has given him reason to hope - because this one act of averaging has closed the gap from Rs.30 to Rs.15.

If this is the only thought process that motivated the urge to average down, it could perhaps be an irrational and emotional decision - and one that could result in throwing more good money after bad. After all, there must be a reason why this stock's price has collapsed by 30% in just 2 months. Is there a change in the fundamentals of the company that has seriously impacted its future profitability? If its not about the company, but a wider market sell-off, has the market cycle turned? Are we now in a bear market where prices are likely to head further down? The top of the last bull market in 2007-2008 saw many investors who came late to the party and bought close to the market top around the 20,000 levels (Sensex) averaging down when the market corrected to 17,000, then averaging further when it went down to 15,000 levels and finally throwing in the towel and exiting with huge losses when markets sank further to 10,000 levels and below. Averaging merely with the hope of reducing the gap between your purchase price and the current market price is never a good idea.

When is averaging a smart investment strategy?

If, in the example we looked at, your client has a deep understanding of the business of the company, his decision to average down may be a very sensible one. If he knows the company and its fundamentals and is tracking its business closely, a fall in market price which in his opinion is not warranted, presents a great buying opportunity. If the stock was good at 100, its become a lot more attractive at 70 : that's provided he understands a lot about the stock and is able to make that considered judgement.

Even the fabled Warren Buffet uses averaging down as a smart investment strategy. That he understands the businesses he buys into, would be an understatement. He buys businesses, not stocks. When he sees businesses he likes available cheaper, he happily invests more in these businesses. Why look around to find other businesses to deploy your cash, when a business you know well has just become a whole lot cheaper? Why not buy more in a business you already own, if its now available at a more attractive price? That's a perfectly rational, well considered investment call.

All of us are not in Mr. Buffet's league, but there is a simple averaging strategy that works well for every retail investor - and that is our humble SIP. The only difference between "averaging down" and an SIP is that averaging down is an impulse that grips many retail investors after seeing a loss in their portfolios, whereas SIP is a strategy that is designed to harness and manage market volatility. You don't start a SIP after seeing a loss, but you do think about averaging after seeing a loss.

What should you advise your clients to do?

The next time you see a client considering averaging down as an investment strategy, what should you do? You know that selling an investment idea on the plank of averaging is an easy sell. But, is that in your client's best interests?

If you believe, from a rational point of view that buying more of the same investment at a lower price is the best possible use of the client's surplus cash, go ahead and recommend averaging. But, if you think averaging is only going to temporarily raise the client's hopes but could lead to even more pain in future, do counsel your client about the pitfalls of such an irrational investment strategy. The best way to dissuade a client who you believe is veering towards an irrational averaging strategy, is to bring to his attention the possibility of an even larger loss that he might face in his quest to somehow make good the present loss, by throwing more good money after bad. Investors don't like losses and try various ways to avoid the pain of losses. It is only when they understand that a decision they take could widen the loss, that they may think twice before averaging just to feel better about a loss on their portfolio.

All content in MasterMind is created by Wealth Forum and should not be construed as an opinion of Sundaram Mutual Fund.

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