What Is Averaging In Stock Market?

In the stock market, it frequently occurs that after purchasing a share, its price begins to decline. If this happens consistently, traders will often sell the share, which will cause a loss even on shares with solid fundamentals.

However, by averaging your portfolio's fundamentally sound equities, you may be able to avoid such losses rather than selling them when their prices decline. Know in detail about What Is Averaging In Stock Market? Therefore, it is crucial to understand:

1. The concept of averaging

2. How does it work

3. When should we do averaging

What is Averaging Down?

In the stock market, this practise is known as averaging. If the prices of the shares we have purchased falls, then we have to repurchase those shares at the new, lower prices, which will reduce our average buying price.

At instance, we invested Rs. 100,000 after purchasing 100 shares of AB Ltd. for Rs. 1000. Now, if the share price of AB Ltd. drops to Rs. 900 per share, each share of AB Ltd. will result in a loss of Rs. 100. We now have three choices to consider:

1. Sell: In order to stop additional losses, we may either sell shares of AB Ltd. for Rs. 900 each and take a loss of Rs. 10,000 on our AB holding.
2. Hold: Have faith in your investment, view the price decline as a passing occurrence, and hang onto your AB Ltd. stock.
3. Buy: The third alternative is to take advantage of the price decline to your advantage and purchase additional shares of AB Ltd. while they are still available at a discount.

Let's say we invested another Rs. 72,000 to purchase 80 shares of AB Ltd. at a price of Rs. 900 each.

With the addition of further shares, our investment will now equal 1,72,000 and we will have 180 shares of AB Ltd. The average buying price of these shares will therefore decrease from this point forward and will be determined using the weighted average method, as follows:

Average Buying Price = P1Q1 + P2Q2 / Total number of shares, where

P1 = Old buying price of AB Ltd.

Q1 = Old quantity of shares bought at P1 price

P2 = New buying price of AB Ltd.

Q2 = New quantity of shares bought at P2 price

Average Buying Price of AB Ltd. = 1000 x 100 + 900 x 80 / 180 = Rs. 955.56

In other words, we now own 180 shares of AB Ltd. that we bought for Rs. 955.56 each, and once the share price of AB Ltd. rises over Rs. 955.56, we will be profitable.

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When should we do Averaging?

We cannot average across all shares since doing so could result in significant losses if a company's stock price continues to decline. The fundamental tenet of averaging is that share prices fluctuate up and down and don't constantly move in the same direction for a certain company. These two crucial factors should be taken into account before averaging a stock:

1. Average in respectable and financially sound businesses only: Prior to averaging, we should confirm that the business is sizable, profitable, and has a debt-to-equity ratio below 1.

Because if a company's financial foundation is weak, it may experience financial strain even at the onset of a short-term issue, which might have a serious impact on its business and produce a sharp decline in share price that may prevent it from recovering to former levels.

2. Determine the cause of the price decline: To determine the cause of the stock's share price decline, we should hunt for company-related news and examine its quarterly results.

You can average the share price of the company if its quarterly results are down one year and increasing the next and there are no long-term challenges, such as any legal troubles or fraudulent practises that are affecting the company.

The averaging down approach, which is primarily applied in bull markets, is a way of averaging when stock prices decline

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