Like birds chirping at the rising sun, investors tweet “buy the dip!” at the first hint of the stock market dropping. Yes, “buy the dip!” makes sense at first blush. It suggests that we should buy assets at the lowest possible prices.
But “buying the dip” is a suboptimal investing strategy.
Let’s discuss why.
The Basic “Buy The Dip” Argument
Buying stocks is a risk. The stocks’ prices might go down after you buy them.
But holding onto cash is a risk, too. That cash could be invested—and grow with the rising market! This is the opportunity cost of not investing.
Either choice—to invest or not—has a risk and a reward. The risk is that the market moves in the wrong direction. The reward is that the market moves in your favor.
So how do we answer whether ‘buying the dip’—i.e. waiting for the market to drop in price before we buy—works?
We can’t predict what the market will do in the future. But we can look at previous market data to “backtest” a buying-the-dip strategy. This is what professionals typically do. And we’ll do that today.
Two Kinds of “Buy The Dip”
Before I insult too many people, let’s baseline ourselves. There are two common definitions of ‘buy the dip.’ As my good friend Andy wrote:
Scenario 1: You’re holding lots of cash for many years, waiting for a big crash. And then you buy after that crash. This is certainly a form of “timing the market.” But is it the same as “buying the dip?”
Scenario 2: You’re holding a small amount of cash, expecting to deploy it in the market in the next few weeks. You wait for a single “red day” of stock market decreases before buying. Even if the market only drops ~1%, you “buy that dip.” Rinse and repeat on a weekly or monthly basis.
I consider both these scenarios to be a form of bad market timing. I say both are “buying the dip.”
But Andy and many others disagree. One argument they make is this: since they are dollar-cost averaging (DCA) anyway, why not wait for a red day to execute their purchase? Buy low, they say. It makes sense.
And in Andy’s defense, I do see a significant difference between the two scenarios. And it’s not just my opinion. The difference between the two scenarios is backed up by convincing analytical data.
Holding onto cash for years is a huge losing scenario. It could cost you millions of dollars (seriously) over the course of a 30-year investing timeline. It underperforms basic dollar-cost averaging by as much as 800% in historical backtests.
Holding onto cash for a few weeks is a slightly losing scenario. Over most historical 30-year investing periods, attempting to buy every dip would drag your overall portfolio down by 0.5% – 1.0%. For someone retiring with $1 million, holding onto cash to ‘buy the dip’ would have cost them ~$10,000 over 30 years. It’s not terrible. But it’s certainly not good!
Note: your emergency fund should still be in a cash bank account. Today’s article is specifically talking about money that you plan on investing. And in my opinion, your emergency fund should not be something you invest.
Waiting for 2% dips drags down historical portfolios by 1-2% over 30 years. Waiting for 5% dips drags historical portfolios by 2-10% over 30 years. No matter how much of a dip you wait for, it’ll impact your portfolio negatively over the long run.
The bigger a dip you’re waiting for, the more it costs you. The best thing to do is not buy the dip at all.
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But Why? Buying the Dip Makes Sense…Right?!
Most people equate buy the dip to buy at a low price. And as we all know, it makes sense to buy assets at low prices. So why doesn’t “buying the dip” work in practice?
The best way to explain it is with a simple example.
Let’s say Adam had money to invest in April 2021. On April 1st, the S&P 500 was valued at $4020. Adam decided to wait before buying—he wanted the market to drop so he could buy the dip.
Unfortunately for Adam, the S&P increased by 4.1% in the first two weeks of April, from $4020 to $4185. Only then did the S&P dip—by about 1.2%, down to $4135.
Should Adam have bought that dip at $4135, even though $4135 was higher than where he was previously sitting ($4020) at the beginning of April?
Should he have held out for an even bigger dip? What if that even bigger dip never comes? The market is unpredictable. I bet Adam felt conflicted, possibly full of regret.
I specifically cherry-picked April 2021 because:
- It was a recent month.
- It was a typical month. We’ve seen similar months throughout stock market history. It’s a perfect example.
For most months, the best day to buy is the 1st of the month. For most years, the best day to buy is January 1st. Early is better most of the time. On average, waiting for a dip is a losing proposition.
A future dip might come. But it usually gets swamped out by larger gains in the meantime.
“Wait for lower prices” makes logical sense. But ask yourself—what if “lower” never comes? The problem isn’t buying the dip. It’s waiting for the dip.
What About Advanced ‘Buy The Dip’ Strategies?
I’m looking at one metric today: price. If you’re making investment decisions based solely on price, then “buying the dip” is a losing strategy.
But I’m sure there are ‘buy the dip’ strategies that utilize other metrics that might work. For example, imagine a strategy tied to the P/E or CAPE ratios.
Note: P/E stands for price-to-earnings ratios. When P/E high, it’s because stocks’ prices are high relative to those stocks’ underlying companies’ earnings. The ratio is generally used to determine whether the stock market is under-priced or over-priced.
If the market’s P/E ratio is too high, perhaps you’d be wise to hold off on investing until it dips by a certain amount. I could see that working. Or you could choose to invest based on Federal interest rates. Or you could use social sentiment metrics—what are people saying about given companies, or about the market in general?
My point is this: there probably are ‘buy the dip’ strategies out there that could work, even those that have worked in previous markets. There are millions of potential if/then correlations, and some of them will lead to investment returns that beat the market average.
But for 99% of the people reading this post—and certainly, the person writing it—we have neither the skill, the time, nor the moxie to make one of these strategies work.
If you’re asking me, don’t buy the dip. History frowns on you. Time in the market beats timing the market.
P.S. – If you enjoy podcasts, check out the Best Interest Podcast!