Opinion: ‘Buy the dip’ is not a good investment strategy, just a good meme

In 2020 alone, over 10 million new brokerage accounts were opened and a vibrant financial media ecosystem emerged to serve these new investors. FinTwit, TikTok financial advisors, Reddit forums, YouTube and blogs illustrate the range of resources available to guide and educate investors. Much of the content is impressive – much better than what was available two decades ago when I started my journey.

Unfortunately, the inevitable snake oil sellers are sneaking in to profit from the gold rush, and some strategies may not be as effective as those presented.

The default with buse the dip

A now common concept – essentially enshrined as a meme – is “buy the dip” (BTD). He suggests buying assets that have recently fallen in price, hoping for a bounce back to the previous level where you can exit profitably, or continue holding with low cost. Although BTD seems like a wonderful strategy, it may be a hothouse flower and a product of the post-financial crisis bull run.

Whenever the SPX stock markets,
+0.57%
faltered over the past decade, the Federal Reserve and other central banks have stepped up to the rescue, intentionally or unintentionally, by providing free portfolio insurance that has allowed risk-takers to thrive while punishing the timid.

As such, many have made buying the dip part of their mental model of how markets work. Most traders and money managers under 40 grew up on this diet, and algorithmic trading systems were trained on a decade of data suggesting BTD is ironclad law.

Now, with CPI inflation at 8.5% at the end of March, central banks may not be as willing to step in with rate cuts or quantitative easing, should we face tough economic times.

Answer these questions

The next problem with BTD is that a realistic strategy requires more detail than “buy when the price goes down”. Some questions to consider: What constitutes a dive? What money do we use to buy? When do we sell?

Investors who have held cash for almost every period over the past decade have missed out on potential gains, and unless you bought near the lows in December 2018 or March 2020, they were likely well behind their “buy and hold” peers who invested when their paychecks arrived.

A drop of 3%, 5% or even 10% is not necessarily a generational buying opportunity.

To test this theory, the chart below plots lows of 1%, 3%, 5% and 10% off the high closing prices over 22 trading days (approximately 1 month), 66 days (approximately 1 quarter) and 256 days (approximately 1 year) as well as relative to the 50 trading day and 100 trading day simple moving averages, assuming semi-monthly pay periods.

The table below compares total returns (including dividends but excluding commissions, fees, taxes, etc.) to a strategy that invests the money immediately.

Yield differential: wait for a drop or invest immediately

dip size

22 day high

66 day high

High of 256 days

50 day SMA

100 day SMA

1%

0.08%

0.04%

0.03%

-0.59%

-1.13%

3%

-0.23%

-0.21%

-0.22%

-0.54%

-1.30%

5%

-1.41%

-0.58%

-0.48%

-4.50%

-7.69%

ten%

-7.36%

-8.11%

-7.50%

-3.21%

-8.22%

Source: Exencial Wealth Advisors

As you can see, there is little to no advantage in waiting for a decline compared to investing immediately. The bigger the drop we wanted, the more time we spent in cash, and the higher our opportunity cost compared to buying as we got cash.

Consider these strategies instead

Sophisticated investors with diversified portfolios will find that there is another way to BTD.

1. Tactical rebalancing. Rather than hoarding cash, you can make calculated adjustments to your asset allocation. For example, if your portfolio is 60% stocks and 40% bonds, you can tactically rebalance to 80% stocks and 20% bonds if the market drops 5% from a level record. Once the market has regained the previous peak, you can rebalance to 60/40.

2. Sell the dip and buy the rip. Buying all-time highs is scary because investors often assume that what goes up must come down. However, financial markets exhibit serial autocorrelation: a tendency to move in one direction over an extended period of time. Business cycles tend to last longer in the expansion phase and contractions are usually short but sharp. Moving to an 80/20 portfolio when the market hits an all-time high and rebalancing to 60/40 when down 10% will likely outperform BTD.

When taxes, fees and commissions are introduced, this strategy may not outperform buy and hold. Nonetheless, it may be counterintuitive to many that buying all-time highs and selling lows historically beats BTD by a significant margin. See this table:

Exencial Wealth Advisors


Buy dips could potentially work on time horizons of one day to one week if implemented well and with proper risk management. However, over longer time frames, following the market trend generally worked better. In practice, BTD is usually implemented haphazardly, using margins or risky instruments, like leveraged ETFs.

3. Buy when there is blood in the streets. Many readers are familiar with this adage from Baron Rothschild, an 18th century British banker. If the opposite approach of buying when the news looks dire works, why does BTD perform poorly when tested? The difference between buying dip and “buying blood” is huge.

If stocks are down 50%, this may constitute a sentiment-driven overreaction, providing an opportunity to add exposure to favorable prices. A drop of 3%, 5% or even 10% is not necessarily a generational buying opportunity.

Here’s a surprise for many BTD enthusiasts: many professional risk management systems do the exact opposite of BTD. Once you get a decline of around 10% or more, along with a pick up in volatility and other risk metrics, it could be a sign that the market has slipped into riskier contractionary territory. The crux of the problem with buying the dip is never knowing in advance when a 10% drop will turn into a 30% to 40% loss in the bear market.

Your personal risk tolerance, income, time horizon and goals determine the optimal approach; While there are no “best” strategies, there are definitely some bad ones. Losses are of course unpleasant, and those fearful of the current drop – or considering buying it – should consult their financial advisor and align their portfolios with their risk tolerance.

Have a realistic plan tailored to you, stick to it over the long term, and the results are extremely likely to achieve your goals.

Jon Burckett-St. Laurent is Senior Portfolio Manager at Exencial Wealth Advisorswith over 17 years of experience in the financial services industry.

Now read: Investors love to brag about their great stock picks, but beware of those who use fancy math to calculate their earnings

More: A mix of 60% stocks and 40% bonds will produce anemic returns over the next decade – here’s how to adapt

And: Want to beat the stock market over the next decade? Add bonds to your portfolio

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