Buying the dip: Is this a good strategy when markets are falling?
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Should you buy the dip? The phrase “buy the dip” means jumping into the stock market after it’s fallen, hoping to scoop up some bargains while they’re available. It’s a popular rallying cry on social media after the market has plummeted, as traders come out and talk about their moves.
But is it a good strategy to buy the dip? Or should investors be “selling the rip,” that is, selling into a short-term move higher in stocks? It’s the perennial guessing game among traders, and usually those looking to make short-term trades in the market come out losers in the end. Still, looking at the market’s worst-performing stocks may be a place to find potential future winners.
So, those looking to make profits in the stock market can take advantage of a “buy the dip” strategy if they follow one rule – stick to a long-term mentality whenever possible.
What is buying the dip and what to watch out for?
A buy the dip strategy is usually aimed at trying to make a short-term profit on a downdraft in a stock, whether that’s as a day trader or a swing trader, who may stay in the stock for weeks or months. Either way, the trader is often looking to profit from a stock that’s been oversold, meaning that it’s declined too much in too short a period and therefore is due for a rebound.
This kind of buy-the-dip strategy is not about buying great companies and letting their business performance drive your returns. It’s all about trying to time the market and get in ahead of other traders and out before investors’ sentiments turn. It’s a tug of war between buy-the-dip traders and sell-the-rip traders, who are looking to unload their stock when it moves up temporarily.
So if you’re buying the dip for a short-term move, you’re trying to outguess the crowd and predict the market’s sentiment. This approach may work sometimes, but study after study shows that actively investing your money ends up losing out to passive, buy-and-hold investing. As the old saying goes, time in the market is more important than timing the market.
That’s the key thing to watch out for if you’re buying the dip – you should expect many trades, if not most, to go against you. You’ll be competing against highly sophisticated AI-powered traders that have every possible advantage available to them. You may sometimes win, but trying to outguess the market by constantly trading is a losing game for most people over time.
Buy the dip – but hold for the long term
There is a common variation on buying the dip that can work, if you stick to it. And that’s to use a dip in the market to add to positions in companies that you think are poised for long-term success. You can buy great companies when they’re cheaper and enjoy higher long-term returns that way. Then you let the company’s performance drive your returns as a passive long-term buy-and-hold investor. You can even use dollar-cost averaging to reduce your risk and make the process easier.
If you play the strategy right, you can take advantage of what’s called reversion to the mean. The idea here is that by buying stocks after they’ve fallen, you can ride them to higher long-term gains as they re-accelerate to their long-run average gains, that is, revert to their mean return.
A stock that has returned 20 percent annually for 20 years will likely return to that average over time, and by buying the dip, you may be able to actually earn even more than that 20 percent.
But you’ll only get that attractive long-term return if you buy and hold your stocks or index funds. If you jump in and out of the market, you’re apt to miss some of the market’s best days.
Buying the dip can work well for investors because it allows them to buy great companies when they’re on sale. As legendary investor Warren Buffett once said: “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”
And where can you start your research on underperformers? Take a look at this year’s worst-performing sectors.
The market’s worst sectors so far in 2022
The list below shows the market’s worst sectors year to date (as of May 25, 2022), according to CSIMarket.com.
- Consumer discretionary – Down 28.4 percent
- Technology – Down 26.1 percent
- Services – Down 19.8 percent
- Retail – Down 18.9 percent
- Transportation – Down 16.1 percent
Sub-industries have fared even worse than these poor numbers. For example, “broadcasting media and cable TV” is down more than 55 percent year to date, while “miscellaneous financial services” has fallen more than 52 percent. Many tech stocks have fared poorly, too.
That means stocks in these beaten-down sectors may be worth investigating further, allowing you to take advantage of a stock or industry’s reversion to the mean.
3 investing strategies to consider if you want to buy the dip
If you’re thinking about buying the dip for the long term, you have a number of strategies that you could use to find attractive returns. Here are three of the most popular:
- Buy the best stocks in a beaten-down sector. If a whole sector has fallen because investors have turned sour on it, you may have an opportunity to buy the best one or two stocks in the sector. You’ll be able to find the most competitively advantaged players and then buy them before the sector returns to investors’ favor in a couple years.
- Buy a sector ETF. If you don’t want to do the legwork of investing in individual stocks, then you may be able to turn to a sector ETF and just buy a stake in all the companies in the sector. You’ll want to be careful that you’re actually buying the companies you intend, because some ETFs can be misnamed and hold many stocks you don’t want.
- Buy the market with an index fund. If you don’t want to do the work to invest in individual stocks or specific sectors, you still have the option to invest in the market with an index fund. A fund based on the Standard & Poor’s 500 Index can give you a stake in hundreds of America’s best stocks, and you can buy while it’s out of favor. It’s a great pick for investors who don’t have the time or energy required for more intense investing, and it’s also Warren Buffett’s recommendation for most investors.
Buying while the market is falling is difficult for many investors, however, because it hurts to lose money and the negative sentiment may be worrying, at least in the short term. That’s why Buffett has said, “The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”
If you’re buying the dip for the long term, you’ll need to have the fortitude to stick with your investments while they fall and hold them through the eventual upturn (hopefully).
Buying the dip is a strategy that can work well if you take a long-term investing approach to your investments rather than a short-term trading approach. With a long-term focus, you’ll be able to take advantage of a downturn and the market’s tendency to revert to the mean, with great businesses leading to great stock performance over time. So a long-term, buy-the-dip strategy can help you focus on finding great companies and then truly buying them at a low price.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.