Is it a good idea to buying the dip? Or should you just get started and invest regularly?
When we start investing, most of us start in the stock market as it is the most well-known form of investment. I also started here and in the beginning, it was quite unclear for me which strategy to follow.
This blog post will uncover my perspective in relation to waiting and buying the dip.
Get ready because this blog post is packed with value 😉
It may be tempting to wait …
Personally, I have invested in two index funds ongoing every month since June 2018, but I also have “opportunity money” that may be used in the stock market over time (maybe to buy the dip). This is part of my investment strategy.
Many are using such investment strategies because they can help navigate in an uncertain stock market like the shown above.
Without a strategy, you can quickly react with emotions rather than specific knowledge – and to follow directions is easier than creating your own, right?
Investment strategies give us a feeling of certainty based on knowledge even we can’t really predict the stock market.
The strategy “buying the dip” is a popular one among many types of investors, no matter their capital or willingness for risk.
What is the strategy of buying the dip?
The buying the dip strategy is as simple as it is logical 🙂
If there’s been a weighty dip in securities (a tradable financial asset) or a stock index, you buy your target stock.
This is of course due to an expectation of an upswing that will bring it back to the ‘normal’ price or beyond.
It has been a successful and popular strategy for years and has been continually endorsed by Warren Buffet – though it has been linked to controversy and criticism (some good arguments are coming below).
There are several assumptions and theories underpinning this strategy, but really…
There is just one basic logic it follows:
The stock market has always restore back to its price given enough time.
Let’s say you have perfect knowledge, which is the mental ability to know that the price will rise after an investment.
Investing in an index (like S&P 500) after a downturn with such psychic abilities may still not be the perfect investment strategy.
How could this possibly be, I mean, what would possibly outperform this?
I’ll give you a clue (until we come back to answer this later on):
What is your hard earned money doing while waiting for a dip? 🙂
Buying on dips
According to believers in the strategy, buying on a dip is precisely the opposite of holding in a speculative bubble.
The shares have been purchased at a discounted price, less than their true value – usually due to being oversold – and this is now the optimal time to invest.
Despite the logic of buy low, sell high, it is actually a contrarian viewpoint.
It is to buy when others are selling like walking in the opposite direction of the herd.
After all, though, it is no secret that markets tend to overreact. In a pessimistic market, prices are often ready to fall quickly for even small reasons – meaning good business will often overcome such a setback.
We need to know why there is a dip in the price of our target investment.
Is it a routine dip because the stock is volatile?
Is the stock being oversold?
Has the company’s book value just decreased?
Buying on the dip, therefore, doesn’t just require the forecasting of price direction and valuation – a big part of it is volatility.
Consider these scenarios
- If the stock isn’t very volatile, but the price has decreased a lot, you may have concerns over the stock’s likelihood of rallying quickly.
- If the stock is being oversold, perhaps due to a PR crisis, this is maybe a good time to buy the dip, given no fundamental change to its underlying value.
- Buying when the price decrease is due to a collapse in its fundamental value may mean the price will never rally back up.
To understand stocks true volatility – how up or down the price is – you need to understand its beta (a measure of the volatility).
The beta will allow you to assess how volatile the stock is compared to the market.
For example, a Beta of 1.5 means that if the market decreases on average by 2%, the stock would be expected to decrease by 3%. You can check the Beta on, for example, Financial Times.
Conventional wisdom suggests that buying on a dip when the volatility is high is good because it is more likely to bounce back.
Furthermore, this buying the dip strategy can be used along with buy-and-hold, particularly as volatility reduces.
In this sense, buy the dip can be just an extra requirement to pull the trigger on an investment.
Why buy the dip has its disadvantages
The biggest downfall of buying the dip is arguably [highlight]the opportunity cost[/highlight] of what you could be investing in while you wait for a dip.
As shown in research by OfDollarsAndData, a simulation running over 40 years, the results showed that:
Even when you have perfect knowledge of when the dip is over, Dollar Cost Average strategy (invest regularly) will often still outperform.
“Your strategy is less important that what the market does”, Nick Maggiulli explain.
This is because the market often isn’t volatile enough to make buying the dip worthwhile, meaning you don’t invest often enough.
While you are waiting with your cash to invest in a dip, you could be investing regularly.
My “opportunity money” is a small part of my investment portfolio and therefore I follow more the Dollar Cost Average strategy. I invest every month no matter how the stock market is developing.
You are never going to avoid the risk of a crash like in 2008.
A debt crisis and a real estate travesty, buying on the dip pose the threat of prices taking a very long time to restore and a difficult guessing game of buying at the lowest point.
Worse than that, if you performed the strategy on the private equity of a mortgage company, you might have been tricked into thinking 2008 was the perfect time to invest.
Many failed to meet their margin calls, with asset-backed securities such as CDOs that were worth much less, with higher risk, than publicly assessed.
Prices do not restore naturally when the underlying value of a company decreases – or worse, they fold.
This is why some investors only use this strategy on indexes – to diversify that type of risk.
If the economy, in general, is going strong there is a lot of growth and a lot of stability.
Investing in equities can pay off through dividends and a rise in earnings
– so if the economy is growing with high confidence, the risk associated with buying the dip may not be significant.
On the other hand, if there is a crisis on the horizon, buying the dip may be too risky. It can be difficult to judge the end of the dip.
As we saw in the 2008 crisis, a lot of equity prices never rallied, whereas the Dow Jones fell for almost two years.
Additionally, as explained, you would have to wait two years until the dip is over. You could be investing elsewhere instead of waiting.
What strategy does stand the test of time?
Dollar Cost Averaging (invest regularly) is perhaps the furthest away from buying the dip and it’s my favorite strategy.
You can reduce the risk of emotions dictating the investment with this less responsive strategy.
When you invest regularly the investment is scheduled already regardless of what’s going on in the market.
You can even automate this investment to free up more time. This suits me really well.
I like to have investments that require the least amount of my time.
That is also why I don’t invest in individual stocks in general but instead index funds.
The beauty in this strategy is that over time, more shares end up getting bought when the price is low.
This is a very low-risk method, a way to survive volatility and yields more reliable results in the long term.
That’s it. I hope you liked it.
I am writing continuously while I’m through the process myself.
I therefore only write what has worked for me.
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