You often hear people say that you should ‘buy the dip’ when the market is down. But just what does buying the dip mean, and should you include it into your investment strategy?
‘Buy the dip’ is a popular term among investors, and you may have heard of it at some point in your investment journey.
In essence, buying the dip is akin to the ‘buy low, sell high’ principle whereby you buy a stock that’s fallen in price, with the expectation that it will rebound in the future.
In this article, we’re going to explain how the buy the dip strategy works, the caveats of buying the dip and how to manage the risk associated with this strategy.
What does buy the dip mean?
Simply put, when you ‘buy the dip’, you’re basically buying an asset, such as a stock, after it ‘dips’ in price. Usually, this happens when there’s a sharp decline in the stock price due to broad market fears, such as a pandemic or war.
However, it could also be down to the company’s performance, growth prospects, and poor forecasts, among other things. Therefore, before deciding to buy the dip, it’s crucial to dig deeper into the underlying reasons for the price drops.
Some investors see buying the dip as an opportunity to buy a stock at a ‘discount’ price and make a profit when the price rebounds (or better yet, eclipses its previous high). This helps to bring down the average price of buying the stock, also known as averaging down.
Basically, averaging down means that you buy additional shares of the stock after it falls in price. By buying an asset at a lower price, you’ll don’t have to wait for prices to rise too high to start making a profit. For example, if you own a stock that’s valued at S$50 per share, you might buy more shares once the price falls to S$40 per share.
Averaging down can be a good strategy if you believe that the stock is just experiencing a short hiccup and is expecting it to turn around.
However, buying the dip usually involves timing the market and comes with huge risks. It also doesn’t necessarily mean that you’ll make money (in fact, you could be losing).
How the buy the dip strategy works
If you’re familiar with the dollar-cost-averaging (DCA) strategy of investing at regular intervals, think of buying the dip strategy the opposite of that.
Instead of using cash to make recurring investments, say for every month, you accumulate your cash and wait for the stock to dip to a certain level. Once that happens, you invest the cash that you’ve stockpiled to buy the dip.
However, determining the specific price ‘dip’ to buy can be tricky, as there’s usually no fixed value for the dip. Some investors choose to buy small dips, while others will take a more strategic approach by setting a benchmark based on the market’s highest level (20%, 30%, 40%, etc.). Once the market falls to that benchmark (say 30%), they’ll invest their saved-up cash to buy the dip.
The general idea of buying the dip is that you get to buy shares at a lower price, and assuming that you hold on to them and the stock continues on an uptrend over time, improve your future gains.
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Caveats of buying the dip
You’re betting that the stock will bounce back to its all-time high (which may not happen)
Unless you’re certain of the business’s outlook and growth, and that the decline is just a temporary blip, you can’t be sure whether the stock will rebound after the dip. If it doesn’t recover, you would constantly be buying the dip or making huge losses.
If the market keeps going up, the money never gets invested
Say you’re saving up cash and waiting for the market to fall to a certain threshold so that you can invest. However, if the market doesn’t fall to that level, you would be sitting on lots of uninvested cash for years.
Although an extreme example, the chart above compares buy the dip and DCA. If you had followed the buy the dip strategy by saving US$100 a month and setting a 50% dip benchmark, you would be sitting on lots of uninvested cash for a period of 20 years. That’s because from 1980 to 2000, there were no 50% dips.
In contrast, if you had invested US$100 every month via the DCA strategy, you would be making 5X the gains over the same period as the market soared upwards.
It’s a risky way to invest in the long-term
Buying the dip usually involves timing the market, which is hard to predict. Furthermore, most investors have trouble distinguishing between a short-term blip and warning signs of a long-term downward trend.
As mentioned previously, there are many reasons why a company’s share price might fall; it could be down to core issues within the company such as scandals, or it could also be due to dismal company performance, negative outlook, or economic factors.
How to manage buying the dip
Despite the risks, buying the dip has been successful for many investors and there are ways you can manage the risks and incorporate it into your investment strategy.
Decide when to cut your losses
When you buy the dip, it’s important to manage your risk and set a benchmark so that you can limit your losses. For example, say if a stock falls below your benchmark of S$10, you may want to cut your losses before it continues to fall.
Pick stocks that you think are undervalued
In value investing, you look for a stock that is underpriced and trading below the company’s intrinsic worth. Usually, corrections in the stock are based on the market reacting to negative news and not because of the company’s financial well-being. Conversely, just because a stock becomes cheaper due to a dip doesn’t immediately make it an asset to your portfolio.
However, this isn’t a walk in the park as it requires a lot of homework, including looking at investment metrics such as price-to-earnings ratio, price/earnings-to-growth ratio, and dividend yields. It takes time, but learning the difference between an undervalued stock vs one that may go down much lower will pay off in making wiser investing calls.
Set a specific benchmark to buy the dip
If you’ve done your due diligence and decided to buy the dip when a stock falls to 20%, don’t wait till it drops further. Big dips are rare and you might miss the opportunity to buy the stock when it’s cheap.
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