Stand Firm In A Crazy Market

Be care what you wish for”, is the first thought that springs to mind when I look at the recent happenings in the Singapore market. It wasn’t that long along when brokers and remisers were bemoaning the fact that the Singapore stock market was quieter than a graveyard.

The criticism can’t be levied at the Singapore bourse, anymore. The vocal critics have got what they asked for – they now have volatility by the shedload.

Volatility has been the order of the day (if not the week), as a raft of mixed signals in faraway China affects not only the Singapore stock market but stock exchanges around the world too.

Swing low, swing high

Those of us who are invested in the Singapore stock market have little or no idea as to whether the shares we own could swing a few percentage points higher or lower, often without any rhyme or reason.

All it takes to move the market these days is an innocent comment here or an innocuous remark there, which could wipe out any of the gains that we have made over the months, and in some cases, years.

In times like this, it is easy to lose sight of why we invest in the stock market in the first place.

We should not – it has to be said – be investing to make a quick buck. Instead, we should be putting our money to work today in companies that could be materially more valuable and substantially more profitable in the distant future.

The distant future

The distant future should be measured in the order of years, if not decades. Consequently, we should not allow the shenanigans in the market today to adversely influence our thinking or shake our faith in the shares that we own.

That said, it is never pleasant to see the stocks that we own suddenly lose a significant chunk of their value.

But as legendary investor, Peter Lynch, once remarked: “Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and mutual funds altogether.”

Provided we have the stomach for investing, it brings us to an interesting question that regularly pops up in times like these: Should we consider averaging down when the shares we own have fallen below our purchase price?

The law of averages

Averaging down is not an investing strategy. Instead it is the arithmetic result of something we do when we buy more shares in a company that we already own at a lower price. That effectively brings down the average cost of holding shares in the business.

Let’s say we bought 1,000 shares in a company at a price of $1. Our investment is therefore $1,000. Should the share price of the company fall to $0.50, it would mean that the “paper loss” on our investment is $500.

If we now buy another 1,000 shares at $0.50, that would effectively bring our total investment in the company to 2,000 shares for a total cost of $1,500.

So, the average cost for each share of our investment is now $0.75. Consequently, our paper loss per share has miraculously dropped from $0.50 a share to just $0.25. That could make us a feel a whole lot better. But it shouldn’t.

Firstly, our paper loss hasn’t changed. It is still $500, even though the loss per share is down by half from $0.50 to $0.25. Secondly, the $1,000 that we have just spent on buying more shares can’t be used anywhere else. After all, you can’t spend the same dollar twice. 

Think rationally

Whether to choose to average down when a stock price falls can be contentious. Some investors believe that a fall in the price of a share provides us with an opportunity to buy more of something that we like at an even better price.

Others reckon that it could be throwing good money after bad. They are both right and they are both wrong, at the same time.

Probably the most rational way to think about whether to buy more shares is to forget about the first purchase in the stock. It is a sunk cost. It is money spent that can’t be unspent.

By putting the first batch of stock out of our mind, we should now look at the universe of possible investments, and choose from those, the best ones. These are the ones that are most likely to reward us well.

If it turns out to be one that we already own, then we have effectively averaged down. But averaging down should not be the reason for investing in a stock. It should be the result of investing in a stock. There is a big difference.

A version of this article first appeared in the Straits Times.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.