THE CONCEPT OF STOPLOSS AND AVERAGING IN INVESTING
Stoploss
and averaging are concepts that a regular trader knows very well. Stoploss is a
price level where the trader ‘stops losing’ in any trade. While averaging out
or averaging down is if not opposite of it but falls way on the other side of
the meaning of stoploss. It means to increase the trade size when the trade is in
loss. For example, trade X has bought 1000 shares at price of Rs.100 and, the
stock falls to 95; he had decided to make maximum loss of 5000 and so he exists
at 95. Here 95 was stoploss. Now if X decides to buy more 1000 or certain
quantity at this declined price or at a little more lower price of 90 for
example then he is said to be ‘averaging’ his position.
Averaging
is considered to be one of the top five trading mistakes. And (to keep)
stoploss is considered to be one of the top 5 important requisitions for
successful trading.
So,
thus these both are concepts in trading. But in investing there is this
presumption that you do not require stoploss. Yes, averaging out is seen among
many investor. Averaging out is employed many times as part of their basic
investing strategy or as a contingency. However, it is a fact that no investor
buys a stock imagining that it is going to come down 50% or more, as averaging
at decline of at least 25% or more is only prudent. You can see how, stoploss
concept is rejected simply when investor opts to keep the strategy of averaging
in his arsenal of tools of success in investment. We have explained 3 stages of
investing in another article. This practice comes at the stage of managing
investments. We will not call it new investment. When you have bought 1000
shares of X Ltd at 100 and buy 1000 or so more at say, 70 or 50. Now your
average or cost price on all 2000 shares is not 100 but 70 or whatever.
Are
we in favour of averaging? Of course yes. We believe it to be one of the most
important concepts to be considered and used by investors for success in
investing world and gaining good returns. Does this have pit falls, yes it
does. In fact Watrren Buffett, the legendary investor, has said, you should not
invest in a stock, which you cannot buy or will not want to buy when it may
decline 50%. Same advice has been given in his lessons buy Indian value
investing master late Shri Parag Parikh in his teachings. There are many ways
to look at this concept. First is that you make sure that whatever you is you
are buying at cheap prices or at good value. There is a good margin of safety. And
even after that for any reason the price of it declines you should be willing
(not compulsory) to buy it more. This states your confidence in your original
purchase and also brings down your average buy cost, making it perhaps a
further cheap buy. So now also you will probably need smaller rise to make
money if you are looking at capital appreciation through rise in stock prices. See,
averaging or buying more shares when your already invested share falls is not
kind of compulsion, if you are not averaging out it doesn’t mean that your
purchase is not cheap or you do not anymore have confidence in your investment
into that company. You may just not choose to buy it more simply because you do
not want to hold more than the number of shares you already have due to variety
of reasons like the limitation of your capital, your overall sectoral or
portfolio strategies and so on. You also have to do your research again in case
any fundamental or other vital change has happened which itself demanded the
stock price to come down to adjust to new lower valuations due to the
development. In that case, you have to reconsider averaging out your investment
in that stock or decide to average on further decline only when your average purchase
costs becomes reasonably cheap.
I
think we mostly discussed about averaging and not stoploss, it may seem. But we
did. Stoploss, in our opinion is not a concept in investing. It may be for huge
fund managers or hedge funds and so on. But for retail guys like you and me.
Following the averaging strategy is better than following stoploss strategy.
They are not strategies per se, but approaches. Yes, if you device them
calculatively into your investment planning then they become important parts
and parcel of it. See, the huge funds have to cut losses, they have to show
quarterly profits, sometimes they bet big on speculative stocks and growth
stocks with steep valuations. So they know when they have baught at 50 PE, and
if its coming down they get out at 35 PE, because they are sure that now its
going to get worth 20 PE or something. So, they hit the sell button and get out
of the investment position. Another thing to keep in mind here is that with
huge funds, they have trading and investing concepts all blurred up mostly. We
are not talking about long only and long term funds. All other funds are aimed
at profits. If they are making good money they get out. And may be buy again.
So logically concept of stoploss seems to fit in their investing strategy. But
for retail guys like us, its best to enter an investment with complete prudence
and good valuations etc.along with readiness to average at lower levels (unless
ofcourse, you are investing like them hedge funds for short term or for a
targeted return only and have predecided to get out of the particular stock in
case of a fall of so and so percentage. But in that case we don’t call it pure
investing or long term investing. We should know it by short term trading. That
is the right word. As it is not either pure trading nor pure investing). The
whole base is that you can not put stoploss while investing because you are
buying the stock with full cash and not in margin and you are buying it for
longer duration and it is not for intraday or till next expiry. These are
technical reasons apart from the basic arguments of value investing. Many of
you will say what if a company, when we invested say, before some months is no
longer worth investing and the fundamentals have changed and so on. Do we still
hold it or exit at some so called stoploss and save the rest of capital?. Yes
and no. Because you should have thought it out before investing. Why did you
buy such stock and at such rate. See, 80 pc of time unless it is a market
meltdown or recession, stocks do perform well and if your company is doing well
it is unlikely that it is going down from the price of you investment even
after that price is a good bargain price. Also as an investor you have to keep
one thing in mind which is that over the short period the price of a stock just
like a commodity is driven by demand and supply rule. But over the long term it
is driven buy demand-supply rule and valuations. Here we are pointing out at
the stock price where it reaches over the period of years after building bases
in technical terminology and not the price range it gyrates over the period of
days or months and doesn’t stabilize there. Now coming back to the point. If
you have to exit because some of your stock is down and out and the firm is not
going to recover or the sector has seen a huge fundamental shift towards worst
then you got to do what you got to do. For e.g if you had Kodak, or some stock
of satyam computer at reasonable price valuations, you had to exit at loss,
making it a stoploss. But again like we said, if you predetermine all possible
variations and follow prudent value investing rules and stick to the plan which
ever you have made, you will likely not require to get puzzled with use of
concept of stoploss in your investment ventures.
So,
now you understand clearly, the concepts of stoploss and averaging in
investing. The bottom-line is that you got to have a clear understanding of
both and a very clear determination as to what are your approaches in regard
with your investments, weather its pure investing or if some stocks you have
bought is for short term without prudent investment valuations and you will
exit it if it goes down certain points and so on. There is not much written or
explained so far regarding these two concepts in investment arena. But
knowledge of the same seems very necessary looking at the effects it can leave
on your long term return on investments.
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