What does it mean to buy the dips?


Some of you may have heard the phrase “buy the dips” at some point in your personal or professional life, or somewhere in your investment education.

Here you will learn what it means to ‘buy the bottom’, how the strategy works, and how to manage the risks associated with the technique.

What does buying the dip mean?

“Buy down” is another way of saying buying a stock or index after it has fallen in value. As the stock price “falls”, this may represent an opportunity to recover stocks at a discount and improve your future gains if and when the stock bounces back to its previous high (or more). .

Buying on the downside is usually done in reaction to short-term price movements and is not usually a strategy associated with long-term investing. If you have decided to buy a stock solely on the basis of a recent drop in the stock price, you are engaging in some form of market timing.

Does the size of the “hollow” matter? Unless you have specifically defined in advance the price drop that would cause you to buy more inventory, it is difficult to define a “dip size” that is universally applicable. This is another reason why trying to buy the downside is a questionable investment strategy for long term investors.

As a general rule, the larger the drop, the more likely you are to win if the stock returns to its previous levels. However, a stock that has experienced an unusually large price drop may have undergone a change in its underlying fundamentals. It may never come back to its maximum.

Image source: Getty Images.

How does the downward buying strategy work?

Buying dips, in practice, involves holding some cash or low risk liquid assets out of the market and waiting for market prices to fall. “Prices” in this context refer to the market values ​​of stocks, bonds, index funds or even cryptocurrencies.

Once the prices come down, whatever asset you follow, you take all or some of the money you held and buy more of the asset. This lowers your overall average cost and can improve your returns, assuming you hold the asset long enough and higher valuations prevail over time.

As an example, take a look at the stock chart of the Vanguard S&P 500 ETF (NYSEMKT: VOO) in the last 36 months:

VOO graphic

Data source: YCharts.

If you had kept enough cash on hand for the months or years leading up to the major drop in March 2020, you could have deployed your money to buy ultra-cheap shares of Vanguard’s S&P 500 ETF when the crash has finally happened.

You would undoubtedly have lowered your average ETF base cost and benefited from supercharged returns to current market highs. But this is not as easy in practice as it seems in hindsight.

Remember, when you look at a stock chart, you are looking at past performance. Once it has already happened, it all seems obvious. The hard part is predicting the dips before they arrive, knowing how far the decline will eventually disappear, then have enough confidence in the asset to believe that it to recover to its previous heights. A little luck doesn’t hurt either!

With cryptocurrency, the game is a little different. Some people are reluctant to deploy large amounts of capital in digital assets, and for good reason. These are emerging technologies with no underlying fundamentals, cash flow or valuation metrics, so it’s really hard to tell the difference between a dip or a semi-permanent crash in these markets.

Take a look at Bitcoin‘s (CRYPTO: BTC) chart on the same 36 months:

Bitcoin Price Table

Data source: YCharts.

Because we don’t have a standardized methodology to assess the underlying fundamentals of Bitcoin (if there are any!) This is probably due to the fact that Bitcoin is speculative in nature. In other words, Bitcoin is traded as a high risk, high reward asset that can ‘fall’ at any time.

If you have a certain amount of money earmarked for cryptocurrency, investing earlier or holding it longer doesn’t necessarily give you a better chance of making money. Plus, since Bitcoin has no cash flow and associated earnings, you won’t run out of dividend payouts while waiting for the next crash to add to your wallet.

The decision to buy Bitcoin or any other digital currency should be carefully thought out in advance, so make sure you understand the risks involved. If you do decide to buy, make sure it is part of a globally diverse portfolio made up of different asset classes.

Man pointing at the downtrend line.

Image source: Getty Images.

Benefits and limitations of buying dips

There are some advantages to purchasing the dips, but there are many disadvantages:

Advantages

  • Lock in a lower average cost for your shares of a particular asset.
  • Can create psychological comfort in knowing you haven’t bought “at the top”.

Disadvantages

  • It is above all a form of market timing.
  • Extend the horizon for the treatment of long-term capital gains.
  • Extend the horizon for the treatment of qualified dividends.
  • Miss dividend payments, which could be invested at lower levels.
  • Extremely difficult to predict in advance, especially when it comes to scale.
  • No guarantee that the asset will recover if the underlying business is damaged.
  • May miss out on further gains if the asset does not decline as expected.

Buy sample dip

As an example, let’s look at Apples (NASDAQ: AAPL) share price over the past 10 years:

AAPL chart

Data source: YCharts.

Suppose you bought 1,000 shares of Apple in January 2019 when it was trading at $ 40 per share, for a total investment of $ 40,000.

At the same time, let’s say you want to keep some of your money on hold until the stock pulls back the next time. Imagine that this amount was $ 10,000.

As it turned out, the stock’s next pullback was in March 2020, when the stock fell from $ 80 to around $ 60- $ 20. upper than your original purchase price!

have you invested all the starting money, $ 50,000, you would have almost doubled your money to $ 100,000 in the space of a year.

Instead, you would be left with $ 80,000 a year later and $ 10,000 in margin – with no way of knowing when to invest it.

Finally, the money you have kept out of the market will not receive favorable tax treatment in the long run until you invest and hold it for a year, and it will also miss the dividends accrued during the period when it will remain inactive.

Simply put, once you’ve decided to invest in a stock, invest the portion that makes sense for your overall financial situation and invest all.

How to manage the risks when buying the dip

If you decide to try to buy the downside of a particular index or stock, there are a few things to keep in mind:

  • Limit the amount you decide to keep out of the market to a small percentage. If you have $ 50,000 to invest, keep only a modest amount uninvested in “dry powder” form, somewhere between $ 5,000 and $ 10,000.
  • Determine a specific price drop you’re willing to deploy money to. If you determine in advance that you will buy more stocks if a stock drops by 10%, be prepared to do so and execute your plan. Don’t keep waiting for more drops – you can wait a very long time!
  • Understand the possible consequences of having uninvested money. You’ll miss out on great tax treatment and the potential for eligible dividends, so make sure you know what you’re forgoing and why.
  • Be aware that this is an unorthodox strategy when it comes to generating reliable after-tax returns.. It may seem advisable to buy the dips, but in most cases it is best to be fully invested at all times. If your asset allocation requires that part of your portfolio be held in cash, that’s another story.

Understand the risks

There are many psychological reasons that buying troughs is a good investment strategy. However, in order to become a successful long-term investor, one must learn to overcome these emotional and psychological biases to give oneself the best chance for success over time.

Purchasing the dips, if you choose to try it, should be done in moderation and with a full understanding of the risks involved. Alternatively, it makes sense to develop a risk-adjusted asset allocation that takes into account your short and long term goals and fully invest your money accordingly. There is a good chance that the “future you” will not be disappointed.


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