I find upward averaging in stocks a lot trickier compared to buying on dips a.k.a. downward averaging. Upward averaging suffers from the typical FOMO (Fear Of Missing Out) wherein one gets desperate to jump onto the rally like there is never a tomorrow! Even though many stocks historically have shown sharp short to midterm rallies, as I keep mentioning in my previous posts, an investment without some strategy creates a lot more chaos in your mind when the outcomes go against you. In that same spirit, for Upward Averaging I do follow some discipline.
Before we dive into the strategy, a clear mention of one assumption and one goal.
Assumption – It’s rather a time back-tested fact, that any high-quality stock will go through a non-linear price appreciation. There will be price volatilities and movements in both directions.
Goal – Warren Buffet’s Rule #1 : Do not lose money. Strategize not to lose money in the market, not to maximize gains.
What signals do I look for ?
Since I am betting on the price to keep moving up, the obvious ones are momentum indicators in the short term. High volume trades pushing up the stock, coupled with some signals on breakout patterns above the trailing moving average price.
Take the example of this stock exhibiting such price movements in an upward trend.
Similarly, viewing the RSI indicators on oversold zones and reversal, plus MACD upward divergence would give some confidence on uptrends.
* There is enough literature available online about these indicators, so I am not going through their description and nuances.*
Now comes the crux of this post. From the time I started building my first partial position in the stock (in other words, buying some shares), the stock price continued to exhibit an uptrend, what do I do next?
Similar to what I do for downward cost averaging, I invest in tranches. The primary difference though is that instead of increasing the value of an investment with each downward cost, I do the reverse i.e. decreasing the value of an investment with each upward cost. The percentage split of the total amount demarcated to invest in that particular stock could be anything, but I typically go for a 50 – 30 – 20 breakdown i.e. 50% on the first move, 30% on the second, and 20% on the third. Now the even bigger question is, at what price point to invest these tranches? A step-by-step example will provide clarity –
- I purchased 20 shares of a stock at INR 100 initially, which is INR 2000 invested.
- I have another INR 2000 hard limit at my disposal (roughly) to an upward average.
- If the stock goes up by 10%, I have a current unrealised profit of INR 200
- At this point, if I need to upward average, I need to create a Margin of Safety (MOS). My MOS is, say, 5% of correction, which I need to be prepared for the stock price to come down to around INR 105 (5% of 110 is slightly more than 5) while still not being in losses.
- To achieve the above, I can at maximum invest 20 shares at INR 110 price point i.e. INR 2200 investment. With this, I break even if the stock price corrects to INR 105. (20 shares x INR 100 + 20 shares x INR 110)/ 40 = 105 average cost / holding share. But I aspire to make some profit in my portfolio, call it the Minimum Appreciation Goal (MAG), after discounting the MOS.
- Hence, to accommodate this MOS and MAG range, instead of investing all 20 shares, I split it up into tranches again. I invest roughly 50% of 20 shares i.e. 10 shares instead at INR 110 levels. This brings the average share cost of 30 shares to (20 shares x INR 100 + 10 shares x INR 110)/ 30 = INR 103.33 . So even if the stock corrects by 5%, my stock portfolio remains positive. Similarly, I continue to follow the margin of safety for the remaining 30 and 20 tranches on upward price movement, assuming the average cost of buying is INR 103.
Here is the visual illustration to make things simpler to understand.
The key takeaways are
- Set an upper cap on additional investments for upward averaging (X)
- Set a Minimum Appreciation Goal and Anticipated Price Correction (Y)
- Split X into ‘n’ Tranches or decreasing values (say, 50% – 30% – 20%).
- Pick the first Tranche such that the total Average Cost adheres to the limits of Y
- REPEAT as the Stock Price appreciates!
This buying strategy blends in a strict margin of safety with a preset exposure boundary on the stock, while avoiding premature euphoria. And in the process, still continue to ride the bullish trend.
