Price Diversification: Protective shield for individual investors against stock market mayhem
By Abu Ahmed
Stock market chaos no longer surprises those who regularly invest in stocks. No one wants to suffer from it, but everyone feels the burn when it hits the market. However, institutional investors somehow reduce the intensity of the financial burn by using the resources at their disposal. On the contrary, individual investors, especially small ones, invariably become the victims of market chaos.
Why does the first emerge unscathed from a crisis while the second boils in it? Do institutional investors have access to investment tools not available to individual investors? Are they better trained in market risk management?
After years of studying market players, it could be said that institutional investors are ahead of individual investors when it comes to infrastructure, resources, and intellectual capabilities. They have financial resources to spread positions, diversify investments and go long for an extended period in an unfavorable environment.
Excluding derivatives, liquidity is one of the key factors that determine an investor’s ability to exercise any of the above options to manage investment risk. Liquidity is generally a scarce commodity for individual investors, especially small ones. They mainly depend on the proceeds of divestment, capital gains, dividend income and their combination for liquidity.
Therefore, with enough cash at their disposal, retail investors will be on par with institutional investors in managing market risk with a chance to emerge unscathed from a market crisis like institutional investors.
The question is how can individual investors have the kind of liquidity necessary for the financial resilience of institutional investors? The conventional approach simply suggests injecting new equity or debt.
The options begin to surface as a solution is sought beyond the conventional paradigm. Among them, price diversification is one of them.
It is an investment strategy that propagates diversification based on price rather than asset class. Under price diversification, shares of the same company are bought at different prices. Quantities purchased at one price are aggregated, tagged and reported as a single investment in the portfolio. Stocks are accumulated when prices start to break down at a certain level.
Each time the price bounces above the buy price of a uniquely tagged lot, the shares of the lot are sold. The cash generated is reinvested in the same stock at a price lower than the price at which the stock was sold. The cycle continues again and again.
Earned profits, realized capital gains and the proceeds from the sale of shares together improve the liquidity of individual investors. Improved liquidity allows individual investors to maneuver their positions in tandem with market changes.
The price diversification strategy works well when combined with technical analysis. Effective practice of the same requires focusing investment activities as follows:
- Select a single, fundamentally sound stock with promising earnings and high beta and trading liquidity
- Perform technical analysis to establish support levels for prices
- Look for the level where the price seems concave
- Build up shares around the concave with capital provisions for the additional purchase of shares in case the price deteriorates
- Quantity purchased at a price treated as a single investment when the market price of the share in a lot exceeds the cost of holding the selling shares in the lot
- Replenish inventory when the price of a stock falls below the selling price
While this strategy comes with its own set of risks, the possibility of locking in investments for an extended period is one of them. Such a situation may lead again to a liquidity risk. Moreover, the effectiveness of the strategy largely includes a crashing market.
The success of the price diversification strategy relies on achieving a balance between the average cost of holdings and the prevailing market price of the stock at any given time.
The concept of a “preference inventory”, which is to uniquely label a group of actions and treat them as a single investment, is not an accepted accounting principle. It was designed and offered as a tool to improve the liquidity profile of individual investors. Therefore, do not use for financial and tax reporting purposes.
The author is a Commerce graduate in Finance and GIS from IBA, Karachi with a Masters in Statistics from the University of Karachi and a Fellowship in Life Insurance from LOMA, USA and a certified trainer by the US-AID program. He has been associated with business schools as a visiting professor giving courses on investment, finance and financial risk management. He is currently engaged in investment research and policy with one of the leading life insurance companies in Pakistan.