Strategies for Stock Trading: Averaging Down or Pyramiding?

Averaging down means buying more of a stock as its price falls, aiming to lower the average cost. This is done to reduce the weighted average cost of capital (WACC). On the other hand, pyramiding involves adding to a position as prices rise, also known as averaging up. The key is to start a position, make incremental purchases in a downtrend (averaging down), or in an uptrend (averaging up) until a set limit or a maximum investment is reached. 

However, many people make the mistake of averaging down when prices are falling, going against the trend. It's crucial to follow the trend, as the saying goes, "the trend is your friend." Buying when prices are decreasing increases the risk of losses because there's no certainty that the price will turn around. Instead, it's better to buy when prices are increasing, following the trend, even if it goes against the notion of buying low and selling high. 

People often fear buying stocks when prices are rising due to the fear of a potential fall. However, buying high and selling higher can be a successful strategy. The key is not to trade against the trend. Pyramiding works well in a trending market, but identifying the right points to add to a position can be challenging. 

Averaging down can lead to greater profits in certain circumstances, but it's essential to distinguish between a stock's individual event and a broader market correction. For this strategy to work, the company should have good performance, minimal debt, and a growing cash flow. 

Ultimately, once in a trade, if it moves in your favor, the probability of success is higher, while immediate movement against you increases the likelihood of failure.

Is Stock Market Investing a Zero-Sum Game?

We often hear that the stock market is a zero-sum game and that makes sense at first glance. If someone makes money in the stock market, does that means someone else is going to lose money? So, the question immediately arises, is the stock market really a zero-sum game?

What is a zero-sum game?

A zero-sum game is a situation where one's profit equals one's loss, so the difference in wealth is zero. So, if you and your friend bet on a coin toss, it becomes a zero-sum game. If you win, your friend loses, and if you lose, your friend wins. Some well-known examples of zero sum games are poker and gambling. The same can be said about casinos and gamblers. If the casino wins, the players lose, and if the player wins, the casino loses. The name "zero-sum" games reflect the fact that if the winner's earnings were added to the loser's losses, the total would equal zero at the end of the game. As a result, one of the distinguishing characteristics of a zero-sum game is that someone must lose in order for someone to win.

Is stock market investing a Zero-sum game?

When it comes to the stock market, the vast majority believes it is a zero-sum game. After all, money earned by someone must come from somewhere, and most people feel it comes from the other loser. However, this is not true. Investing in stock can be mutually beneficial. Because of the varied risk tolerances of the participants, trades in the stock market are dependent on future expectations. Someone selling his stock does not necessarily indicate he is losing money. He might have made a lot of money and was eager to book it. Similarly, if one investor sells, there's no reason to believe the next investment won't profit as well. Both parties have a chance to win in this situation.

Let’s take few real-life example:

Mr. X bought a stock of XYZ company when it was trading at 500 rupees. When the stock ran up to 1000, he decided to sell his shares and the buyer of those shares was Mr. Y. Now, Mr. Y was just as patient as Mr. X and saw XYZ’s shares soaring to 1500 rupees. So, he decides to sell the shares at 1500 rupees. And this goes on and on.

So, in this story, who’s the loser? Well, nobody. Everybody is a winner in this stock as long as XYZ’s growth story continues.

Overall, a zero-sum game isn’t the right description of investing. As the company expands and becomes more valuable, the stock market can increase the wealth of both the participants & economy over time.Dividends are an essential component that is frequently overlooked when viewing the stock market as a zero-sum game. Corporations earn profits from sales and distribute a portion of those profits to shareholders in the form of dividends. If the market were a closed system with only buyers and sellers, it might be thought of as a zero-sum game. It is not, however, a closed system because firms continue to pour money into it as dividends. The classic mistake people make is that they think that shares of a company are just the same as a coin in the coin toss or those chips in the casinos and that’s where the whole confusion starts. The reality is that a company’s stock is very much a living, breathing entity. It can bring more money in the market or it can suck money from the market depending on the company’s financial performance.

So, the answer is no. The stock market is not a zero-sum game. It can be a positive-sum game for investors of good stocks and a negative-sum game for investors of bad stocks. 

There is a zero-sum game also in the stock market and that is in derivatives, i.e., futures and options.