‘Buying the dip’ does NOT work: here’s why

Common investment wisdom dictates that share investors should not try to time the market.

No one has a crystal ball and there is no way of knowing if there has been a trough until well after prices have risen back.

Yet almost every stock investor tries to buy the dip. 

After all, it’s human nature to try to pay a cheap price — and not just for shares, right?

So why do we have to avoid trying to time the dips?

‘Good deals don’t stay around forever’

Frazis Capital Partners portfolio manager Michael Frazis explained the reason in a very simple way to his investors last month.

Let’s say you think the market is overvalued now and that it will crash in the near future. So you’ve prepared a cash pile to swoop on the bargains when the dip comes along.

Frazis said it’s nearly impossible to execute this plan because no one knows the market has bottomed until after everyone has moved on.

“If you move to cash based on (whatever) macro fear, you usually have only the briefest of periods to enter at lower prices before the crisis passes,” he said.

“Good deals don’t stay around forever.”

The other scenario is that your prediction was completely incorrect and the share markets continue to rally. Then you’re underinvested and missing out on returns.

“You are stuck: you have to buy back in at higher prices and risk losing twice, or stay out of the market forever,” Frazis said.

So the best way is to just invest without regard to timing.

“We are doing what we did at the lows: staying invested.”

Frazis is optimistic about equities anyway.

“This is somewhat justified as US$1.9 trillion of US government spending is about to wash through markets and central bankers seem determined to keep interest rates at lower bounds,” he told investors.

“Those caught under-invested mid last year have had to buy in at higher levels or miss out completely.”

Mathematical proof that ‘buying the dip’ doesn’t work

Ritholtz Wealth Management director of research Michael Batnick and finance blogger Nick Maggiulli crunched some numbers in February last year as the COVID-19 market crash started happening.

If you invested $1 every day since 1990 in the S&P 500 (INDEXSP: .INX) since 1990 but put in an extra dollar on days when it fell by 2% or more, you’d end up with $41,079.

If you invested the same amount of money evenly each day over the same time period, you’d actually end up with a better return of $41,348.

It feels counterintuitive, but it’s a mathematical lesson not to try to buy the dip.

But you say $2 on dips is not enough. Let’s ramp that up to $100!

Well, would you believe it? According to Maggiulli and Batnick’s numbers, ‘buying the dip’ lost even more money! Evenly timed investments would have returned $176,732 while putting in $100 during the dips would have only ended up with $149,913.

Incredible.

“This is one of those rare pieces of analysis that might have an affect [sic] on how I invest,” said Batnick.

“The message is clear. Don’t wait to buy the dip — just keep investing, because the earlier you start, the better off you’ll be.”

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Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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