Buying The Dip – The Psychology of Investing Success?

Investing
Investing

“Buy the dip” is a succinct comment you’ll see below the videos and posts of many financial contributors across online media. What does it mean and is it a fool-proof investing strategy?

In this article, we’ll look at the pros and cons of ‘buy the dip’ as an investment strategy and look at whether it’s easy or difficult to implement in your own stockbroker account. Is it just a platitude repeated by losing investors to reassure each other or is there a kernel of real investing wisdom within this concept? I’ll share my personal opinion in this article. This is not financial advice.

Let’s find out:

What does ‘buy the dip’ actually mean?

Buy the dip means buying shares (or other investments) after a substantial fall in the price of the asset.

In ordinary retail terms, it’s the equivalent of buying an item after it has gone on sale, although as we’ll explain later this isn’t the perfect metaphor for this strategy.

It’s an active investment approach because it involves the investor making decisions on-the-fly in response to market movements, rather than following a pre-determined schedule of purchases.

Advantage of buying the dip:

  1. Buying the dip encourages buying low and selling high

The art of succeeding when actively investing is buying low and selling high. Doing so will maximise the capital gain enjoyed on the transaction.

However, this is easier said than done. Many retail investors actually become attracted to the stock market after a period of prolonged upward rises. This means that they’re inherently more likely to buy shares when they are fully or over-valued. In essence, they actually buy high and often sell low after market turbulence.

A review of investor data by Forbes shows that equity investors only generated 2.6% annualised returns in the 10-year period to 2013. This is in stark contrast to the average market returns created by the stock market over the same period.

Clearly investors do a poor job at timing their investments.

Buying the dip as a mantra could be helpful because it only encourages investment after a significant fall. Therefore, by definition, somebody buying the dip is not buying at the market top. This may come as some comfort to those making an investment.

Encourages buying at value

The broader ‘value investing’ strategy consists of buying companies at rock bottom prices when they have fallen out of favour with investors. Great companies don’t stay out of the limelight forever, and value investors are banking on the success of their companies eventually filtering out into the market consciousness resulting in price increases.

‘Buy the dip’ is a simpler version of value investing, in that it can also encourage investors to pick up companies that have fallen out of favour or are unfashionable stocks to own. Value stocks didn’t have a tremendous decade to 2020 however since the 2022 bear market, they’ve performed much better than the average growth tech stock.

Gives investors the courage to continue investing

Over the very long term, the winners in the stock market aren’t those who chose the best stock of the year. It’s everyone who actually participated in the broader market.

The losers are those who didn’t invest at all and settled for low-interest returns on cash.

Why do some retail investors flit in and out of the market? They are dictated by fear and use bad news as an excuse to sell their investments are head to a place of comfort and certainty. However, investors who sell out after crashes are naturally harming their long-term returns because they usually miss out on the rallies that occur afterwards.

Buying the dip is a useful mentality because it reminds investors that down markets are buying opportunities and are never the right moment to leave the market altogether.

Drawbacks of buying the dip

Buy the dip might be a short and easy concept but it doesn’t actually line up with all academic theory on financial markets.

Dip is a relative term that means hindsight

 Buying the dip is a simple attempt at timing the market, which involves buying shares when they’re at a trough, and selling them when they’re valued highly.

However, actually putting these concepts into practice is frustratingly difficult in real life. That’s because you can only define a trough or a peak with the benefit of hindsight.

If a share falls in value by 10%, is that the dip? What if you buy then it falls a further 10%? Is that another buying opportunity? What if the share slowly falls by 90% of its original value.

A ‘buy the dip’ investor would unthinkingly continue to add to their holdings all the way down, which with hindsight would look like a terribly series of events.

Shares fall in price for a reason

Let’s return to the analogy of grabbing a bargain in a shop during a sale event. When investors buy the dip, this is what they feel they are doing. They’re buying the exact same item (i.e. 100 shares in a company) at a discount to the price available a short time ago.

This isn’t precisely the case, however. Remember that a share is simply the right to participate in a future series of cash flows, i.e. dividends. The value of these future flows is unknown, and the market simply makes a prediction based upon the fundamentals of the company, economic conditions and so on. Yes, you’re buying part of a company, but you’re effectively buying into a range of probability-weighted scenarios of different cash payouts. These scenarios and the likelihood of each continue to change each day following headlines and updates on events that may impact the company.

If the market devalues a share, it implies that the probabilities attached to favourable outcomes have reduced, and the probabilities of poorer payouts have increased. While you may be buying the same financial instrument – the possible payouts that it is likely to lead to are now worse.

And almost like being offered two different lottery tickets. One offers a 50% chance of winning $100,000 and the other offers a 40% chance of winning $60,000. The first is clearly more valuable. If you bought the first at a higher price to the second, you wouldn’t necessarily feel like the second is a better value simply because the price is lower.

The efficient market theory states that the prices of financial instruments always reflect all publicly available knowledge about a company. A cheaper price simply means that the investment is worth less, therefore buying it after a fall shouldn’t provide an investor with an edge.

Overweight in cash?

Buying the dip requires additional cash on hand to use for future purchases. This implies that if you’re buying the dip, you weren’t fully invested in the market.

Studies have shown that being fully invested is one of the best things you can do to improve your market returns. Therefore if you’re actively preventing your cash from being deployed in the hope you can buy the next dip – you’re hampering your long-term returns.

Consider what would happen in a smooth bull market such as from 2013 – 2020, in which the stock market rarely fell by more than 10%. If you had sat in cash waiting for the next buying opportunity – that opportunity may have never come and your cash would have missed the chance to be part of a long bull market.

Overall – is buying the dip a sound strategy?

Overall my personal opinion is that based your entire approach around buying dips isn’t a sound strategy. It could result in your missing out on the easiest returns of all – the returns of a smooth and steady bull market.

However, it’s a handy mantra to repeat when you find yourself sticking to your guns and investing during a bear market. Anything that gives you the courage to keep investing during the good times and the bad is helpful!

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