Overview
I talked briefly about “buy the dip” in the article Don’t Fear Down Markets. While that article made the case for not being overly bearish when market conditions seem bleak, this article will serve as a counterbalance of sorts.
So many people have heard the phrase “Buy the Dip”. Put simply, when stock markets contract, investors should load up on as many shares as they can afford. While this advice sounds logical, is buying stocks simply because their price is down always a good idea?
I would argue that it’s not, and that it’s actually quite foolish to go on an unhinged buying spree simply because markets are down. “Buy the dip” isn’t always good advice.
“Buy the Dip” Has Some Merit
Before we look at the problems behind the “buy the dip”, I want to first mention that it’s not entirely bad advice. In fact, under the right circumstances, buying when markets are down can be very financially rewarding for investors.
During 2020, I purchased stocks on several occasions, and one of the factors that contributed to my higher-than-usual purchase activity was the fact that a lot of stocks were selling at, or very near, their all-time lows.
At the time of this writing, all the shares I purchased in 2020 have regained a considerable amount of value, with some returning to, or even exceeding, their pre-COVID prices. The return in value for these shares has resulted in double-digit percentage gains for me.
Buying any asset when prices are low is not inherently a bad idea. I mentioned before that I adhere to value investing, and the whole point of value investing is to purchase assets when they sell for less than what they’re truly worth.
Before the COVID-19 pandemic, many of the shares I ended up buying were trading close to their intrinsic values. That is, the gap between their market price and “inherent” price was narrow. In value investing, this “gap” is known as the Margin of Safety. The narrower the margin of safety, the more likely an investor is to overpay.
After the pandemic was declared, market prices of most stocks collapsed, widening the margin of safety. Because my margin of safety suddenly increased and stayed wide for much of 2020, I proceeded to load up on shares.
Let me make myself abundantly clear: low stock prices served as a catalyst for my purchases, not as my primary motivation. The shares I ended up purchasing were already on my radar well before the pandemic was declared, and I had already performed some preliminary analysis before the pandemic struck. By the time I purchased, I was already aware of all the relevant facts. The lower-than-usual price was simply the last piece of the puzzle.
“Buy the dip” is sound advice, but only for investors who know what they’re doing. Just because stock prices are low doesn’t mean an investor should purchase whatever stocks they can get their hands on.
When “Buy the Dip” Becomes Detrimental
The problem with the “buy the dip” mentality is that it makes two implicit assumptions:
- Every stock at a low price immediately has investment merit.
- The stock will return to its original, higher price. It’s only a matter of time.
Let’s discuss the first assumption. Imagine walking into a clothing store that had a fire sale going on: everything in-store is 70% off. That sounds like a good deal, right? But would you suddenly purchase as many clothes as you could from that store without assessing the quality of the merchandise? Sure, you can buy a shirt for $9 instead of $30, but if that shirt is low quality to begin with, you’re simply buying a low-quality shirt on sale.
The same logic applies to investing. Say you want to purchase shares of Company A, which currently sells for $100 a share. If the price suddenly drops to $30, would you proceed to load up on Company A’s shares?
What if you found out that Company A’s industry has been in the doldrums for years, and as a result has been financially struggling for a long time? Not only that, but Company A has struggled to regain its footing because of years of bad corporate culture and low employee morale. With this in mind, is that $30 a share still an attractive proposition?
In another article, I analyzed Warren Buffett’s Wonderful Company, Fair Price quote, where I discussed why this quote is so powerful. Buffett’s quote is a reminder that focusing exclusively on price alone is not enough to ascertain investment merit. A bad company selling for a bargain is still a bad company, the only difference now is that it’s cheaper to purchase.
Now, let’s shift our attention to the second assumption. From what I’ve observed, especially throughout 2020, the reason that “buy the dip” is such enticing advice is that most people put their hope on this assumption: that a price rebound is inevitable.
Investment pundits who preach “buy the dip” simply point to financial history, such as the 2007-2008 Global Financial Crisis, and show that financial markets will always rebound. If markets have always rebounded, then surely there’s no better time to buy when it’s at a low point, right?
While some stocks do rebound, there is no guarantee that all of them will. For example, before the Global Financial Crisis, Citigroup stock was selling for more than $400 USD. At the time of this writing, its stock price hovers around $70 USD. It has not exceeded $100 USD ever since the Global Financial Crisis. Imagine buying Citigroup shares in hopes of a price rebound, only to find out it never recovered.
Just because a stock drops 30% in price doesn’t mean a 30% price rebound is inevitable. Buying shares on this basis alone is a textbook example of speculating because there is no assurance of safety of principal and an adequate return.
Down Markets Do Not Mean no Analysis is Required
Whether the market goes up, down, or sideways, before any major investment decisions are made there should always be a satisfactory level of analysis to justify a decision.
Let’s go back to our clothing store example. Say that you’ve been eyeing a specific shirt from that store, but the price is still a bit too high for you. Based on your comparisons with other stores, the shirt you want still remains the best option, specifically in terms of its quality.
Finally, the shirt you want goes on sale and drops to a price low enough that you can afford. You proceed to purchase, knowing that you are about to secure a very good deal because you’re buying a high-quality shirt for less than its original price.
Regardless of what market you currently find yourself in, there is no excuse to forego thorough investment analysis. Buying any asset simply because you can afford it is not a valid reason. Take a look at penny stocks: companies that trade for extremely low prices, many of which sell for less than a dollar per share. Would you go on a penny stock buying spree simply because you can afford them? How many of those penny stocks are actually investment-grade?
Remember, an investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. If you buy stocks simply because the markets are down, you’re not investing, you’re speculating – you hope that the price will rebound, or you assume that the market will eventually correct itself. An investor doesn’t make a decision based on hopes or assumptions, they make them based on facts and analysis.
Wrapping Up
“Buy the dip” makes sense in certain scenarios, but it is by no means universally sound advice. Just because stocks drop in value doesn’t mean an investor can go on an unhinged buying spree.
When pundits tell people to load up on shares during a market crash, the two major assumptions being made are every stock is investment-grade, and that prices will eventually rebound, resulting in an inevitable payday.
An intelligent investor knows that a stock’s investment merit must be justified on both quantitative and qualitative grounds, and that not everything that goes down will eventually come back up. Hoping that stock prices will rebound is not a valid investment strategy, it’s speculation.
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