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averaging down: ETMarkets Learning Guide: Why averaging is good for an investor & bad for a trader

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averaging down: ETMarkets Learning Guide: Why averaging is good for an investor & bad for a trader

“Rule No. 1 is never to lose money. Rule No. 2 is never to forget Rule No. 1,” says Warren Buffett. In a simple world, it means that when you are out to make money in the stock market, take decisions in line with your financial goals.

Thus, it’s imperative to understand that a market strategy may bring profit for an investor, but the same may result in losses for a trader. This principle also applies to the strategy of averaging.

Investor Vs TraderBefore we come to the concept of averaging, let’s understand the difference between a trader and an investor. Time horizon is the key factor that differentiates the two categories.

Both are out to make money in the market, but an investor looks for large returns over a long period of time with the motto – buy and hold.

Traders, on the other hand, opt for lesser but more frequent profits. Simply put, traders try to cash on both, rising and falling markets by making quick entry and exit.

“If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” These words by Warren Buffett concisely explain what investing is all about, and also the difference in the mindset of an investor and a trader.

Primarily an investor earns profit via the power of compounding or by reinvestment of the profit, and often both. Traders, meanwhile, try to make profits by buying at lower levels and selling at higher levels or vice-versa.

Normally, a trader would look at a return of 10% every month from his deals, while an investor aims for a 12%-15% return over a long period. The goals of the two categories too may be different.

A trader, for example, would be aiming to buy a car in a few months. The aim of an investor could be planning for retirement.

Investment tools for the two categories are often different. An investor would opt to buy large-cap shares and invest in bonds & mutual funds.

Traders would prefer more volatile small & midcap shares and also use commodity & currency market fluctuations to make quick profits.

AveragingSimply put, averaging is buying more stocks when the price falls to bring down the overall cost of holdings. For example, you had bought 10 shares of company A at Rs 100/share.

So, your total cost was Rs 1,000. Suppose the stock price of A falls to Rs 50 and you buy 20 more shares for Rs 1,000. Now you have 30 shares by spending Rs 2,000, which means per share cost is Rs 2,000/30 or nearly Rs 67. This is down from Rs 100 earlier.

And, now if the stock price rises you would make more profit. This is also called the ‘Buy On Dip’ strategy.

Warren Buffett is one of the many success stories of averaging. The basis of this strategy is that the market recovers over a period of time.

The proponents of this theory cite the recovery after the dot com bubble, the crash of 1987 and the historic one after the Great Depression.

Averaging: Good for traders or investors? By its nature, averaging is a long-term strategy primarily. Thus, it’s not suitable for the traders as it may increase losses in the short term if the bearish trend persists for a long period.

Traders have a short time horizon so a slow recovery may be detrimental to their cause. Secondly, there’s no guarantee that the strategy works 100% even in the long-term, so it’s more of a risk for the short-term traders.

Lastly, with ‘buy on dip’ or averaging you are practically timing the market – buying at lower levels hoping the market would go up in the future. And, in practice, even the best have failed to time the market, more so in the short term.

Thus, it is risky and potentially a loss for traders. However, evidence shows averaging is likely to work for an investor – who prefers growing portfolios with a long-term perspective.

(The author is Chairman, TradeSmart)

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