What is buying the dip?
Some investors consider the rewards of buying the dip worth the risk as a way to build wealth in their share portfolio quickly. We take a closer look at the pros and cons of this investment strategy.
An introduction to buying the dip
The term ‘buying the dip’ refers to the practice of buying assets (such as shares in a company) soon after they have suffered a price decline.
Investors who follow this strategy view the drop in price as a buying opportunity and hope to profit from short-term volatility in the company’s share price. Essentially, they are betting that the decline will be temporary and that by buying the dip, they can increase their gains when the company’s share price eventually rebounds.
Consider the example of a high-growth ASX technology company whose share price has generally trended upwards over the past year. Suddenly, something sparks a sell-off in the company’s shares, and its price drops precipitously.
You do the research and conclude that the company still has significant long-term growth potential and that this panic selling will only be short-lived. You decide the shares are trading at an attractive discount, so you take the opportunity to buy the dip. If your faith in the company pays off and its share price rises to its previous level, you will achieve some pretty handsome gains.
The mean reversion theory
Buying the dip relies on the financial theory of ‘mean reversion’. This theory suggests that the prices of shares and other assets will eventually return (or revert) to their long-run average. So, if a company’s share price falls below its long-term trend, this would be a signal to buy, whereas if it increases above the trend, this would be a signal to sell.
Buy the dip investors seek out shares whose recent performance differs significantly from historical trends. If a share’s price has dropped far enough below its long-term average, investors will purchase the share, hoping to make a profit when the price returns to normal levels.
However, there is no guarantee that the share price will always revert to its mean, and near-term movements in the price could instead be the first sign of a shift in the long-run average.
When should you buy the dip?
The hardest part about buying the dip is working out whether the dip in a company’s share price is only temporary or the beginning of a longer-term downtrend. Therefore, before you think about buying the dip, you should make sure you have a firm grasp of the company’s financial position, business model, and growth prospects. This information will help you determine the likelihood of a near-term share price recovery.
All sorts of factors can cause share market volatility, some of which may have very little to do with the company you’re looking to invest in. Sell-offs in one sector or market can quickly spill over into others.
Sometimes, panicked investors can develop a ‘herd mentality’, causing shares in certain companies or sectors to become oversold. This is particularly true for shares that have recently experienced high growth rates. Nervous investors may start taking some of their profits off the table if they feel their gains are in jeopardy.
The trick when employing a buy the dip investment strategy is identifying the times when the causes of market volatility aren’t directly related to the company you’re looking to buy.
Perhaps reports of sluggish economic growth in China spark a broad market sell-off – but if the company you’re looking to buy doesn’t do any business there, maybe the drop in share price presents an excellent opportunity to buy the dip.
On the other hand, if the drop in share price is driven by significant fraud allegations levelled against the company’s top executives, maybe it wouldn’t be a great time to buy the dip (as this might signal that further share price declines are on the way).
The point is that employing this strategy requires you to understand the sources of share price volatility and how they relate to the fundamentals of a company (or companies) that you would like to invest in.
The other tricky part about using a buy the dip strategy is working out what a ‘dip’ actually means. For some high-frequency traders, a daily share price drop of 1% might represent a dip, whereas other investors may wait many months for a 10% correction.
It often helps to look back over historical trends to work out what normal movements in the company’s share price tend to look like before deciding whether a recent decline offers a good opportunity to buy the dip.
For all these reasons, buying the dip generally works best when you purchase shares in a company you already own or one you already follow closely. You should understand the company and believe in its long-term potential – otherwise, you’re just gambling!
Buying the dip and averaging down
The added benefit of accumulating shares in a company you already own is decreasing your average purchase price through an investment strategy called ‘averaging down’.
Let’s say you purchased 500 shares in that ASX technology company we mentioned earlier when its shares were trading at $10. Not long after you make your initial investment, the company’s shares are sold off heavily, and the price drops 20% to $8. Soon afterwards, it rebounds to a new high of $12.
If you bought the dip and purchased another 500 shares at $8 a share, your average purchase price for the 1,000 shares you own would decrease from $10 to $9. This means that when the share price hits $12, you are sitting on gains of more than 30%. Whereas, if you hadn’t bought the dip and had just held onto the 500 shares you initially purchased for $10 a pop, your gains would only be 20%.
This is closely related to a ‘dollar cost averaging’ investment strategy. Under this strategy, investors split their total investment into smaller, regular purchases over time rather than investing a lump sum all in one go.
The key difference between buying the dip and dollar cost averaging is that true dollar cost averaging investors are agnostic about price – they will invest periodically regardless of what is happening in the market. Those who buy the dip, on the other hand, are actively trying to time the market and are only buying at opportune moments when the share price drops below its long-term trendline.
When should you think twice before buying the dip?
It’s important to point out that buying the dip can be very risky. This is because it is a contrarian investment strategy – you’re betting that the rest of the market is wrong and that a share that has recently suffered a price decline will soon reverse its downtrend and quickly recover.
But if the only reason you decide to invest in a company is that its share price has recently declined, this can get you into a lot of trouble. There’s no way of knowing that a company’s share price won’t just keep falling.
So, as we’ve already discussed, if you follow a buy the dip investment strategy, you should try to mitigate this risk by only focusing on companies you understand well.
And make sure you always diversify – otherwise, you risk losing all your money investing in a genuine dud!
You should always tie any investment decision you make back to your assessment of a company’s real underlying value. This will help you determine whether or not you think you are paying a fair price for a share of the company.
If you believe in a company’s long-term growth prospects and think that a recent pullback in its share price means that its shares are now cheap, this is the best time to buy the dip. This is because you are basing your investment decision on your understanding of the company’s growth potential.
Because buying the dip can be risky, you should also avoid using your emergency funds to pursue this strategy. Basically, you shouldn’t invest any money you can’t afford to lose. While buying the dip can maximise your upside (if it pays off!), there’s no saying when (or if) the share price will ever recover.
If the share price declines further and you need your money back in a hurry, you may be forced to sell your shares at a loss.
Final thoughts on buying the dip
While it sounds great in theory, buying the dip can be a challenging investment strategy to implement successfully. To make it work, you need to make consistent, good predictions about the market’s future direction (and no one can do that 100% of the time).
The risk with buying the dip is that you can lose a lot of money if you get it wrong.
However, if this is an investment strategy you would like to follow, always focus on companies you understand well and avoid risking any of your emergency funds on these types of trades.
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