“Buy low, sell high!...Buy the dip!”
The investing world is full of memorable clichés and tweets from long-time investors that can sometimes be misinterpreted by newcomers to the stock market. One phrase you’ve likely heard, particularly whenever stock markets take a tumble, is: “buy the dip.” Spoiler alert: It has nothing to do with sour cream or potato chips. Buying the dip involves purchasing stocks during a market decline, and closely relates to another popular adage: “buy low, sell high.” Many novice and experienced investors alike might wonder if this approach is appropriate for them. Before we explore the merits of buying the dip, it’s important to know what it really entails.
What does “buying the dip” mean?
Stock market enthusiasts love charts. Whether it’s tracking the price of an individual security or a broad index such as the S&P 500, these visual representations of price changes over time allow investors to instantly recognize how their portfolio or the market generally is faring. Stock prices often rise over time, but as anyone who invested in 2022 knows, that appreciation is not guaranteed. They can also dip downward.
Buying the dip can be a tactic — however, it’s not really full-fledged — of investing when securities prices have come down from a recent high (for example, 10% or 20%) with the expectation that the price will recover. Historically, major stock index has recovered from a drop of that scale, although the time it takes for that to happen can vary wildly. The same cannot be said about every stock. There is a long list of equities that have fallen and never recovered.
How does buying the dip work?
Returns from owning equities has to do with the price you pay when you buy. This is especially true over short holding periods of, say, five years or less. If you buy a stock at a “low” price, you may have a chance of making higher gains than you would if you were to pay a “high” price.
But what constitutes a high or low price? This is where things can get tricky. Every stock has what's called an "intrinsic value." This represents the true value of the stock (or any other asset), regardless of what investors are willing to pay for it at a given time. There are several ways investors can measure this, and you can often find suggestions of a company's intrinsic value by reading analyst reports.
The intrinsic value of a stock is less volatile than its day-to-day price. A stock might go down 10% in a day – but its intrinsic value and potential are unlikely to change that quickly. For example, If a stock falls to $20, but its intrinsic value is calculated at $30, there’s potential to generate a return off the dip. If the stock price is $40, then you might consider waiting until the price declines to buy in, also consider that there can be an increase from the $40.
Buying the dip example
The wisdom (or folly) of buying the dip may be best seen in hindsight. For example, let’s say you were scared off from buying stocks by the 2008 – 2009 financial crisis when markets fell a shocking 48%. Over the next several years, you stood by as markets recovered dramatically. Then came 2018, when the S&P 500 once again pulled back, this time by 6.2%. For someone looking for an entry point, the end of 2018 may have been an excellent time to buy the dip. The S&P went on to rise 29% in 2019, 16% in 2020 and 27% in 2021.
Pros and cons of buying the dip
Buying the dip can lead to some positive outcomes. But there are other points to consider, including:
- By buying low, you can increase your chances of never paying top dollar for securities, which may also increase your potential for capital gains. It is impossible, however, to know when you’re really buying at a market bottom. Prices may fall further.
- Once invested, you will still be exposed to unpredictable future price changes. Buying the dip is, essentially, an attempt to time the market — something even the most seasoned investors have been unable to do on a sustained basis.
- Being ready to buy the dip requires having cash in reserve, ready to deploy at short notice. Since that cash typically produces little or no return, it can drag down your total portfolio returns and may cause you to miss out on other investment opportunities when markets are steadily rising.
- Some market rallies have been known to stretch for years. You may ask yourself, how long are you willing to wait on the sidelines?
Things to consider when buying the dip
Buying the dip does have some merits. If there are specific investments you’ve been eyeing, but feel they’re too expensive right now, then a dip could allow you to buy them at a discount. Having a system in place may help. Here are some things investors can consider:
Setting aside a cash amount (as an example, about 5% of total investable assets), as a reserve to buy a stock or ETF that’s down. The idea behind this is to remain disciplined and reduce the chance one can lose out by sitting on the sidelines too long.
Maintaining a shortlist of stocks or funds you’ve researched and wish to own. You could determine the price at which you’d purchase them at, or the percentage amount you’d like to see them fall before buying in. Then, track them for as long as it takes.
Consider your hold and exit. Is this an investment you intend to hold indefinitely or sell once it rises a certain amount? What will you do if it continues falling? One consideration can be a stop-loss order on the stock, through which you automatically sell if your losses reach a certain level.
As with any investment, monitor any changes within the company, in its competitive landscape or in the markets more generally that might undermine the assumptions that made you want to own it in the first place.
It’s time in the market that counts
Remember, if buying the dip was consistently effective, everyone would be doing it. The fact that stock prices and markets go down, often for extensive periods, proves it won't work for every investor every time. At best, buying the dip can be a way to pick an entry point for an investment you already wanted to own.
Accepting that you can’t time the markets and, for the bulk of one's portfolio, you might consider making equal contributions at regular intervals that will be allocated to a diversified set of underlying assets. That way, you can buy more stocks or units of funds when prices are low than when they are high. It also means you remain fully invested. So, when the markets do rise, you’ll stand to benefit. This leads us to another investing adage that many investors stand behind: “It’s not timing the market so much as time in the market that helps grow your wealth.”
