Let us begin our discussion with a quote from Warren Buffet.
“Be fearful where others are greedy and greedy where others are fearful”
Down market is an opportunity for buying stocks of good companies at a cheap price.
But this offers its own set of challenges. If you don’t know how to read a financial report or have little experience with market trends, you might need the advice of an expert.
You can gain both, professional management and a diversified portfolio of stocks by investing in a good-quality mutual fund, rather than trying to pick individual stocks.
Let us understand this concept in greater detail with the help of an example –
Assume you are a long-term fundamental investor, with investments in a company A.
You believe that the fundamental thesis behind the stock is positive and you are looking for additional buying opportunity with every sharp decline in the price of this stock.
Then, to answer the coveted question – should you invest when the market is down?
A straightforward answer is, Yes!
Why should I invest when the market is down?
The advantage of investing, when the market is sliding down, averages the cost of investing.
Let us assume you have bought 100 shares of a company at Rs. 50 each
The price came down to Rs. 30 and you add 50 more shares.
The price further came down to Rs 20 and you add 150 more.
So, total amount invested = Rs 5000 + Rs 1500 + Rs 3000 = Rs 9500
Total number of shares = 100 + 50 + 150 = 300 shares
Thus, cost of each share = Rs 9500/300 = Rs 31.67
Hence, you will see your average cost of investing has come down to Rs 31.67 which is less by 40%
Now assume the share bounces back to Rs. 50.
Profit = Rs 5,500 which is 57% of the total investments of Rs 9,500.
Now, if you had not added the additional units when the stock price was declining, at Rs. 50 you would have no profit.
Thus, the main advantage of investing when the market is down is averaging down the cost.
The advance of averaging down is that an investor can bring down the average cost of holding a stock quite substantially.
Also, with stock rebounding, you tend to lower your breakeven point for the stock position
When does averaging work?
Averaging as a tool comes with a higher degree of risk.
Remember, it is more suited when an investor invests keeping in mind a long-term horizon.
You should only apply the method when you understand the business model of the company and you strongly believe that the company shall grow at a justified pace in the future, owing to its business model.
If you are trying to copy the ace investors, remember, you may fall into the trap as you are not aware of their underlying thesis behind the stock.
Disadvantages of Averaging Down
Averaging works only when the stock is likely to rebound.
But, if the stock continues to move south, the investor may rue the decision to average down. We believe as an investor you should take utmost care and carefully assess the risk of averaging down.
Remember, during the 2008 crisis, even the best names lost sizeable capitalization and investors’ lost a substantial amount of wealth despite averaging the household names of that time.
Another, disadvantage of averaging down is that the weight of the stock or the fund in the overall portfolio could increase substantially than the anticipated weight in the portfolio.
This could distort the overall risk-return profile of the portfolio.
In the words of Warren Buffet
Averaging down should be done on a selective basis for specific stocks, rather than as a catch-them-all strategy for every instrument in the portfolio
We believe the above strategy will work well for high-quality and blue-chip stocks, where the risk of going bankrupt is low and the business is fundamentally sound and sustainable to provide ample earning growth.
Thus, to conclude, we believe that you should continue investing even when the market is falling but you should definitely have a long-term goal.
Disclaimer: The views expressed in this post are that of the author and not those of Groww