Buy The Dip - Does It Work?
Updated: Sep 1, 2022
We all know what buying the dip in the stock market is about. It is a very simple and commonsensical strategy. When stocks fall in price, we buy. But if you look beyond that, there is also an allocation perspective to it. Because to buy the dip, you need to have money around to deploy when stocks drop in prices. That means you need to have cash sitting around before that happens. So there are opportunity costs involved as these are cash that you could have invested elsewhere prior to it. So let's look into buying the dip a bit more systematically.
Should I buy the dip when the stock market falls?
For now, let's put aside the allocation consideration and imagine that you are now in a situation when the stock market is falling and you happen to have cash lying around. So should we buy into the dip?
We all like to buy things cheap at a discount but we don't like it when the discounts keep getting steeper after we bought them. So there are always 2 opposing forces clashing within you. On one hand, you know this is the opportunity to go in at lower prices but you fear the stock market may continue to fall. On the other hand, if you don't, you are afraid you might miss the boat if the market rebounds.
Now, there is no way to know for sure which direction the market will go at any point in time. So don't bother trying to pick tops and bottoms. Even so-called experts with all the resources and experience fail miserably at it. But if history is of any significance, then yes you should be buying. And you don't have to buy it all in one shot. You can do it progressively. Because the stock market does climb back up over the long term. Or at least, the US stock market has been doing that over the past almost 100 years (see chart below).
That in itself lends a strong reason for you to be buying into a solid diversified basket of stocks as it falls. Of course, that is also provided that time is on your side because it can take a long time for the stock market to bottom and recover.
Should I reserve cash to buy the dips when it comes?
Now, that we have established a case for buying into dips, we can move on to talk about the more complicated issue. Should we make it part of our strategy to set aside money so that we are ready to buy into dips when it comes or is it better just to pump it all into stocks? The answer is not as obvious now because whether you are better off depends on how the market moves then.
If you manage to catch a scenario where the market starts falling and then recovers, that is ideal. But if the market keeps trending up without any crashes or pullbacks, then that is the worst scenario. Because you would then still be sitting on your cash while watching the markets fly.
To get more color on how an elaborate buy-the-dip strategy would perform against a single lump sum investment in the stock market, we can do a simple study.
Buy The Dip vs Lump Sum - The Setup and Rules
Let's assume we set aside $100,000 for investing a basket of stocks such as the S&P 500. As an added note, I am using the S&P 500 price index here which excludes dividends because that is the only index that stretches way back to the 1920s in Yahoo Finance (Ticker: ^GSPC). And we are looking at an investment horizon of 20 years which should be long enough to cover different market cycles and generate decent returns.
What we will do is test out the buy the dip strategy over rolling 20-year periods from 1928 to 2021. That means we look at how buy the dip performed against a lump sum investment in S&P 500 from 1928 to 1947, 1929 to 1948, 1930 to 1949, and so on until 2002 to 2021. We will begin the strategy in January of the starting year and end it in the December of the ending year.
The rules for the Buy-The-Dip strategy are as follows:
1. For every -5% dip from the market peak, you invest $5,000.
So that means if the market is down 10% from its peak, you would have sunk in $10,000 at that point. Once the money is invested, it stays invested for the entire period under consideration. Note that the market can always undergo a pullback and then proceed to make new highs. In that event, the next dip of -5% will be measured from the new high (illustration below).
With a capital of $100K, that gives us a total of 20 clips of $5,000 to play around with. This should be enough to capture the bulk of the fall during bear markets that can happen over the span of 20 years. Any undeployed capital will remain as cash.
2. Undeployed capital or cash generates 3.3% a year in returns
Money that is not invested into the S&P 500 is assumed to be parked in a cash equivalent such as the 3-month T-bills. While T-Bill yields have been on the very low side since the Great Financial Crisis, they were considerably higher in the past. Between 1928 and 2021, T-Bills have on average delivered 3.3% per year. So, for simplicity, I will assume in this study that undeployed capital at any point in time earns interest at a rate of 3.3% a year.
3. Prices are filled using close prices and there are no transaction costs or slippages
Some technicalities for those who are more detailed and quantitative in nature. In the study, I assumed we are able to fill the prices at the close of the day when the dip exceeds the threshold. On top of that, there are no transaction costs or slippage in executing those trades to buy into the S&P 500.
Buy The Dip vs Lump Sum - The Results
So how does buying the dip stack up against a lump sum investment in S&P 500 in this setup?
Buy the dip delivers positive returns across all the 20-year periods.
Buying the dips delivered positive returns across all the 20-year periods in this study meaning you made money after 20 years no matter which year you started. It is just a matter of how much. A lump sum approach, on the other hand, made a loss in 3 out of 75 of those 20-year periods. So, yes, you can theoretically still lose money even if you hold your investments for 20 years. Those periods happened to cover the Great Depression, the worst bear market in US history, between 1929-1931 when S&P 500 lost as much as 86% from its peak.
Buy the dip outperforms the lump sum only 28% of the time.
From 1928 to 2021, there are a total of 75 rolling 20-year periods. And out of these, buy the dip emerges the winner only in 21 of them or approximately 28% of the time. If you observe the periods during which buy the dip outperforms, you will see that they coincide with major recessions and bear markets i.e. the Great Depression from the late 1920s to the early 1930s, the stagflationary periods in the 70s, the Dot Com crash, and the Great Financial Crisis in the 2000s. The rest of the time, buying the dip underperforms the lump sum approach. This is not unexpected given that the stock market not only grows over time but also tends to stay in an uptrend more than a downtrend. And in terms of CAGR, they are too far off from each other. Buy The Dip has an average CAGR of 6.1% across all the 20-year periods while the lump sum approach delivered 6.8%.
Buy the dip lowers the maximum losses
It should be no surprise that buy the dip strategy helps to reduce risks by lowering the maximum loss experienced. Because there is always the chance that your money is not yet fully utilized before the worst crisis hits. In contrast, with a lump sum approach, you are already all in on day one. So the largest loss with buy the dip strategy is at worst the same as that of the lump sum.
On average, buying the dip reduces your maximum loss by an average of 13.5%. across all the 20-year periods considered. The maximum reduction can go as far as 53.6%. And out of all the 75 20-year periods under observation, 48 (or 64% of them) experience a reduction in the maximum loss.
As we can see, buying dips has its benefits. It can reduce risk in terms of lowering the maximum loss you may experience and can outperform when we run into significant market crises. But it does come with a cost. And that is the opportunity cost of missing out on a good run in the stock market because the probability is stacked against you. So again, it boils down to a question about tradeoffs and what is suitable for you. Do you want to give up some potential gains in return for lower risks? This is not something unique to buying dips. It is the case with almost any strategies you want to devise. Because there is no holy grail out there. Every approach you take will come with its own strengths and weaknesses.
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