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Are you catching the Falling knife?

When a stock that you have reduces in price, it is a normal tendency to buy more shares at reduced price. This way the overall average cost of the stock comes down. This is normally called Averaging Down.

The question is when to average down a stock or when not to. If you are averaging down on a stock, when the stock breaches multiple support levels, you might be trying to catch a falling knife.

When is it said to be catching a falling knife? Well, no one can tell exactly. But what one can do is to do some analysis to check the reason behind the falling of the price of the stock. Is it because of the overall market trend or something related to the stock alone.

If the falling trend is because of a overall market trend, due to some global news affecting the market. And if have a strong conviction on the fundamentals of the stock, then that is a good opportunity to buy more stocks based on your overall allocation of the stock in your portfolio. In the name of averaging down, one should not increase the weight of the cost for the stock beyond the optimal level, this could become a disastrous to the overall portfolio performance.

On the contrary, if the falling trend is because of a reason specific to the stock, it is better to not accumulate more stocks in the name of averaging down. If the reason is more crucial to the future business of the underlying business, it is better to exit by booking a loss than to average down and being struck at the bottom of the stock. This scenario is called catching a falling knife, you will tend to hurt more than to benefit from the falling price.

What if you missed a pullback by not averaging down?

Normally a fundamentally strong stock will start a breakout after a long period in the same price range, and then pullback to a certain level and rebound with full force. One may average down during the pullback slowly with some strategy before the stock rebounds.

Do you need to catch all the falls? Not necessarily. You can follow some strategy in averaging down. Instead of averaging down on 1-2%  price down, one can have average down if/when the price falls down more than 5%, and upto 10%, for a increased allocation. One should note how much percentage the average cost will decrease, when you try to average down before averaging down. Then take the decision whether the increased allocation is worth it. Again allocation and the buying price are the key for the performance of your portfolio.

June 6, 2017

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