Investors are always looking for the perfect strategy to beat the market. The efficient market hypothesis suggests that consistently beating the market is an impossible goal. Still, some traders believe prices can be anticipated because stocks move in repeating up-and-down patterns, driven by investor sentiment. This theory has given rise to the “buy the dip” strategy.
What Does Buying the Dip Mean?
Investors who buy the dip are looking to purchase a stock only when it has fallen from its recent peak. They assume that the price decline is temporary or a short-term aberration and that the dip is an opportunity to buy shares at a bargain price.
Typically, people who buy the dip already own shares of a company whose price has declined from a recent high. Dip buyers generally are looking to build a more prominent position in a stock and use temporary price declines—aka “dips” in the share price—to increase their holdings.
Those who buy the dip expect the stock’s price to bounce back and exceed the purchase price. As the investor buys more shares of a stock, they already hold during a dip, they “average down” to lower the net average price of their position in the stock, enhancing performance.
How to Buy the Dip
Investors who follow a buy-the-dip strategy purchase stocks only under certain conditions, keeping cash in reserve to make purchases when the stock market retreats.
Some investors might buy the dip if a stock price drops amid a long-term upward trend in the market. Many of today’s investors have succeeded with this strategy during the bull market that we recently enjoyed.
Market pullbacks can be unnerving. But generally, the market will bounce back to a new high after a pullback. So, the buy the drip strategy tends to work well.
In the absence of a bull market, investors may buy the dip if they anticipate an upturn and are willing to wait for a future increase in the stock price. In either case, investors are reacting to short-term price movements, which is a very different approach to investing for the long term. Buying the dip is an attempt to time the market, which can be risky.
To buy the dip, an investor sets a threshold for a price decline and saves cash in the interim. A threshold of 30% means that the investor will only buy when a stock price drops more than 30% from a recent high. They buy the stock and wait for it to rise to a new high, at which point they prepare to buy after another 30% decline.
There are risks to buying the dip. If the market begins a solid upward trend, they may not see another 30% dip again for some time, perhaps several years. Once there is a pullback, they’ll buy the stock not at a discount but rather at a premium over the last purchase price.
When the strategy is working, the larger the threshold percentage, the more an investor stands to gain. But when it doesn’t work, the losses can be considerable.
Buying the Dip versus Dollar-Cost Averaging
Dollar-cost averaging is a strategy in which an investor buys a specified amount of stock—for our purposes, let’s say $100—at regular intervals.
This approach calls on investors to buy $100 of the target stock monthly, regardless of price. The strategy is intended to reduce the impact of volatility and avoid any attempt at timing the market. Over the long term, the strategy maximizes the chance of reducing the average price over time. It’s intended to reduce costs while having a positive impact on returns.
Buying the dip is also intended to lower the average price over time. When you compare these two strategies, there are periods when buying the dip outperforms dollar-cost averaging.
But an investor who sets a high threshold for the dip—say, 40% to 50%—may run into trouble in a bull market. If the market fails to retreat by the designated threshold, the investor will continue to hold cash without investing it.
Holding cash for long periods is ill-advised, as idle money doesn’t generate a return, and inflation can erode its value. Plus, an investor can miss out on valuable dividends when not invested in stocks.
According to a 2022 report from Hartford Funds, dividends made up an average of 40% of total returns from 1930 to 2021. By sitting on cash, investors can miss out on an essential source of growth.
Managing Risk When You Buy the Dip
Managing risk is an integral part of the buy-the-dip approach. Sometimes a stock price drops for a good reason, like a change in its fundamental value. Maybe the company released a disappointing earnings report, or experienced a widely publicized scandal.
Any investor buying the dip needs to research and analyze the fundamentals to avoid going long on a stock that will only drop lower in the future. If you’re going to buy the dip, it’s essential to establish risk parameters when pursuing a buy-the-dip strategy:
- Set a limit on the amount of cash left uninvested. A good rule of thumb is no more than 10% of investable assets. Understand the risk of holding excess cash, including lost dividends and potential tax consequences.
- Be disciplined about the price decline. If the threshold is a 20% decline, don’t be tempted to hang on and hope for further drops.
- Use a stop loss. This is a set price at which a position should be sold. Say a stock price falls from $20 to $16. At $14, the investor will close the position to limit the loss should the price continue to fall.
- Watch out for longer-term downtrends. The stock is a downtrend when a stock price continues to fall, reaching a lower low with each consecutive decline. This is not the time to buy the dip. Buying the dip is a reasonable strategy when stocks are in an uptrend, pulling back but moving up to an even higher high.
- Know your biases. You must understand the psychological and emotional biases that may influence your investment decisions. Don’t let the pleasure of “getting a bargain” prevail over objective analysis. Some fundamental research can prevent regrets later.
Should You Buy the Dip?
The principal benefit of buying the dip is reducing the average stock cost over time. But there are many reasons to avoid this strategy. First, it’s a type of marketing timing, and academic research in finance has proved that trying to time the market accurately is virtually impossible. Attempts to predict a decline, let alone a decline’s magnitude, is very difficult.
If you hold too much cash, you’ll miss out on potential dividend payments that might be reinvested. Reinvesting dividends can potentially enhance returns. Finally, unless you’ve analyzed and understood the company’s underlying fundamentals, you could easily buy a stock with a good reason for declining.
Disciplined investing for the long term, based on a financial plan that considers your risk tolerance and returns objectives, is far less risky than buying the dip—and it’s more likely to meet your return objectives.
