While it is widely believed that beating the market on a regular basis is not doable, some investors think they can anticipate stock prices since they go up and down in a repetitive manner due to sentiment. Such an idea is what created the investing strategy known today as ‘buying the dip.’
Buying The Dip Explained
Buying the dip involves purchasing a stock that dropped from its recent record high. Investors who practice this type of strategy see the slump as a short-lived incident only and their chance to buy shares at a discount.
Dip buyers are usually already holding some shares of a company whose price fell from its latest peak. By buying during a pullback, investors can use the short-term price retreat to ramp up their investments and position in a particular stock.
When you buy the dip, you expect the stock’s price to recover immediately and rise higher than the purchase price.
As you purchase additional shares of the stock you already own during the decline, otherwise known as averaging down, you reduce the average price at which you bought the stock, further improving your performance.
Using the Buy-The-Dip Strategy
Investors who buy the dip have specific conditions when purchasing stocks. The conditions involve holding some cash or less risky, liquid assets to buy stocks when the market pulls back.
Some investors buy the dip when the stock slips during a long-term uptrend. Today, many investors have turned a good profit by taking advantage of a plunge that occurred during a bull market.
Buying the dip is an effective investing method because while market slumps are a matter of concern, the market is likely to rebound to reach a new high.
If the market is not in bullish territory, you can buy the dip if you predict an increase and are willing to wait for the stock’s future gains. Nevertheless, you are reacting to short-term changes in the price. Such a response differs significantly from investing for the long term.
Moreover, buying the dip means you need to time the market, which is a strategy that carries quite the risk. In buying the dip, you first need to establish a price drop limit and make sure that you keep cash in the short term.
For example, a 30% limit will require you only to purchase once the stock’s price has gone down over 30% from its recent peak. You buy the stock and wait for it hit a new record high, at which point you get ready to purchase after an additional fall of 30%.
Buying the dip can have some detrimental risks. If the market starts a strong uptrend, the additional 30% decline may not happen again for a few years. Once the price retreats, investors will not be buying the stock at a bargain. Instead, they will purchase the stock at a premium over the last buying price.
You can benefit significantly from the buy-the-dip strategy when it works properly, and you have set a high percentage limit for the dip. On the other hand, if the strategy doesn’t work, you could end up with substantial losses.
Buying The Dip: Keeping Risk In Check
Keeping risk in check is crucial when you’re buying the dip. You need to research and look into the details to not go long on a stock that will only weaken further in the future. If you intend to purchase a pullback, you should have some risk parameters.
To set those, you first need to determine how much of the cash you’re holding will not be used for investing. Not exceeding 10% of investable securities is usually preferred. You also need to grasp the risks of keeping excess cash, including lost dividend payments and possible tax penalties.
Second, you must be disciplined about the price fall. For instance, if you set the limit for the dip at 20%, you should fight the urge to continue holding on and hoping for the price to slide further down.
The third thing you need is a stop-loss to sell your position at a pre-determined price automatically. Let’s say you bought the stock at $20 and placed a stop-loss order at $15. Your stop-loss order will automatically close the position at $15 to minimize the loss should the stock price continues its plunge.
Additionally, keep an eye out for long-term downtrends, as those do not present an excellent opportunity to buy the dip. You can see a downtrend when the stock reaches a lower low with every consecutive drop.
On the other hand, you can buy the dip if the stock is in an uptrend, retreating but then rising to an even higher high.
Finally, you need to know and understand the psychological and emotional biases that could impact your investment choices. The thought of buying at a discount should come after practical analysis, not before. Note that some critical research can help you avoid feeling investor’s remorse in the future.
Buying The Dip: Should You Do it?
While buying the dip lowers a stock’s average cost over time, there are several reasons to think twice about using this investing strategy.
First and foremost, it involves accurately timing the market, which research has proven difficult to pull off. Predicting a slump or the extent of the slump alone is too hard of a task to do.
The part where you need to keep cash can also put you at a disadvantage. If you have excess cash, you’ll miss your chance on potential dividend payments that can be reinvested, making you miss out on the opportunity to increase your returns.
Lastly, unless you’ve done your research and are familiar with the company’s primary fundamentals, purchasing a stock with a decent reason for falling is a straightforward process.
Instead of buying the dip, you can take the less risky approach: long-term investing. Investing for the long term carries fewer risks than buying the dip, plus it considers your risk tolerance and profit goals, and it’s more likely to meet those goals.
