Every now and then, you should take a step back and re-look at your portfolio of stocks.
The lull period in September usually allows some time off for calm reflection.
It is during such periods that you can take a long, hard look at your stock positions.
For companies that have performed well, give yourself a pat on the back.
And for those that are not, treat it as a learning opportunity and learn from your mistakes.
But as you do your review, a common dilemma arises.
For stocks that are performing well, should you add on to your position?
Conversely, for positions that have performed poorly, should you buy more to lower your average cost?
It’s not an easy decision to make and many investors may end up in a quandary.
Let’s walk through the decision process so that you are better equipped to tackle it.
First off, let’s define some important terms in this discussion.
When you add to a position whose share price is rising and above your original buy price, we call this “averaging up”.
“Averaging down” will then refer to buying more of a position when it falls below your buy price.
You may hesitate when it comes to averaging up as it will increase your overall average buy price.
The belief is that there is a greater margin of safety when you purchase at lower valuations.
This statement is not wrong in itself, but the problem is in defining what “low valuation” refers to.
Is there a reason why the share price had moved up?
It’s good to determine if the increase was due to an improvement in the underlying business, or purely due to sentiment.
If it was the former, that would mean the share price is rising in tandem with earnings and free cash flow, making the business more valuable.
In such cases, it may make sense to add on to the position if you feel confident about the company’s prospects.
However, if the rise was wholly due to sentiment and does not seem justified, then you may decide to hold back and wait for more clarity before committing your capital.
Psychologically, it feels easier to average down on a position.
That is because you can justify it by saying that you are lowering your average buy price.
Not only that, but a declining share price may make the business seem more like a bargain, tempting you to allocate more capital to it.
However, the same rule applies once again.
Check to see if there is any reason for the share price decline. It could be due to poor earnings, a deteriorating outlook, a one-off negative event (such as a lawsuit) or weak sentiment for the sector.
Pinning down a reason is not always easy, and at times, there may not be any logical reason why share prices move down.
The decision to average down, therefore, should not be taken lightly.
If your investment thesis remains sound, and nothing has occurred to cause you to question your original assumptions, then it makes sense to average down.
But if additional risks have surfaced or the outlook has suddenly turned negative, you may wish to reconsider averaging down.
Take note that during this COVID-19 pandemic, many companies are expected to report poor earnings and a muted outlook.
You need to sift through the business commentary to determine if the long-term fundamentals of the business are still intact.
Only then can you make an informed decision about whether to average down, or not.
Keeping an eye on the business
Did you notice a common theme here?
The decision on whether to average up or down should be anchored on business fundamentals.
It should not be driven by sentiment or emotion.
Neither should it be tied to whether the stock price is making new highs or lows.
Remember that ultimately, it is the business that will drive how the shares perform.
As Warren Buffett said, if the business does well, the stock price will follow.
Get Smart: Remember to pace your purchases
Whether you decide to average up or down, remember to always pace your purchases.
The economy is going through a tough time now so it’s important to ensure you have sufficient savings.
Do not over-commit and deploy cash that you may need for expenses or a planned big-ticket purchase.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.