Averaging up, a good strategy to let your profits run

Most of the investors think of averaging down the cost of their acquisition when the stock price is going down. This investment strategy is based on the premise that the stock price will bounce back and, therefore, when the price goes up, the lowering down of average cost of acquisition will turn around the initial loss-making investment into a profitable investment.

However, what does an investor do when the price of stock goes up from the level of purchase price? Should the investor purchase more of the stock or should the investor book profit on the existing holding?

Before we go into the merits and demerits of averaging up, let us try to understand the strategy with an hypothetical example. Ramesh buys 100 shares of company XYZ at Rs 200 as he expects the stock price to go up to Rs 220 within a month. After a week, the stock price as expected went up to Rs 207 and Ramesh buys 100 more shares at Rs 207 per share. A week after that, the stock price had moved up to Rs 212 and Ramesh buys 100 shares more at Rs 212 per share. In the third week the stock price had gone up to Rs 215 and Ramesh buys 100 more shares at Rs 215 per share. In the fourth week, the stock price reached Rs 218 and Ramesh decides to offload the entire holding of 400 shares at Rs 218 per share. Ramesh’s cost of acquisition of 400 shares came to Rs 83,400, while the sale price of his entire holding of 400 shares was Rs 87,200, netting him a clear profit of Rs 3,800.

It is clear from the above that the decision whether to buy more of the stock or book profit and exit from the stock will depend on the estimated price level the stock is expected to touch from the purchase price. A correct decision on the target price will make the investment more profitable than the profit on initial investment, but a wrong decision can wipe out the entire profit and, in fact, may even result in a loss. In the above example, after going up from the level of Rs 200 to Rs 215 in the third week, if the price of XYZ had declined to, say, Rs 207 (instead of going up further to Rs 218) and Ramesh had sold off his entire holding of 400 shares at Rs 207 (to stop his losses), Ramesh would have suffered a loss of Rs 600, instead of the profit of Rs 700 he would have made if he had exited from the initial investment of Rs 20,000 on 100 shares.

So, averaging up is as risky as averaging down the cost of acquisition, but averaging up can be done profitably on stocks that are in bullish phase, just as averaging down is profitable in stocks that are in a temporary bearish phase. Averaging up, or buying in tranches, helps in mitigating the risk associated in putting the entire amount at one go, where a single price level decides whether the investment would be profitable or loss-making, whereas in averaging up, the lower price levels cancel out the losses suffered on higher price points and, thereby, help mitigate the losses.

Remember the old adage: Stop your losses and let your profits run. Averaging up is a winning strategy to put that into practice!