Whether it is due to a pandemic or rising interest rates, as investors see their portfolios fall to new lows, we have all asked ourselves the burning question: should we buy the dip? In its simplest form, “buying the dip” can be explained as an attempt to time the market, essentially trying to snatch up bargains on either specific stocks or funds. Due to its simplicity and application to practically all tradable items from stocks to crypto, many investors have debated this strategy.
Seeing our favorite companies that we have meticulously analyzed and dissected fall, say, 10%, 30%, or even 50% and more can be heartbreaking. And to many, buying the dip seems like an obvious choice. But investors shouldn’t be too excited to hop on these new deals. First, investors should take note of why the stock has fallen in the first place. Take one example where investor Bill Ackman, billionaire hedge fund manager of Pershing Square Capital, took this strategy to heart. After Netflix stock fell over 20% in January of 2022 due to warnings of slowed user growth issued in its guidance in its 2021 Q4 earnings report, Ackman took a 1.1-billion-dollar stake in the media streaming giant—the pinnacle of buying the dip. Believing the new share price represented a compelling long-term opportunity, Ackman, among other investors, considered the 20% discount on a household name like Netflix a steal. Three months and a cut of 200,000 subscribers later, Ackman would close his Netflix position for a loss of $400 million. Ouch. When looking at a company like Netflix, and the decisions of Ackman, many would agree that a stock that was once trading near $700 per share, now trading at $400, could be a great deal…until it falls to $200. Thus, we should be reminded of the old proverb: past returns do not predict future ones. Though, many investors would say if Ackman just held a company like Netflix for long enough, he would eventually turn a profit eventually… right? Well, not exactly. Though it may seem impossible, even some of America’s largest companies do eventually go bankrupt. Take Sears Holdings Corporation, for example, better known as Sears. Once America’s largest and most successful retailer, Sears stock has fallen from its all-time high of $193.00 in 2007 to literal pennies, trading at $0.14 today, a 99.9% decrease. Whether investors bought the Sears dip at $150, $75, or $10, they still would have lost almost the entirety of their investment. Though these two examples, Netflix and Sears, make buying the dip strategy look bleak, success with this strategy is still plausible; but careful analysis must be made. By analyzing the fundamental reasons for a company’s dip and understanding the upside—which may be information that is simply not available or known without hindsight—it is possible for stocks to be oversold and create buying opportunities.
While buying the dip on specific companies may be too risky, what about the market as a whole? Historically, the S&P 500 has returned on average 10.5% since its inception in 1957 and has consistently been considered a safe investment. These factors make the S&P 500 a safe investment for any long-term portfolio, regardless of the time you invest, but what happens if you could time the market? In a test run by Charles Schwab, where different theoretical investors invested $2,000 every year overlooking the S&P 500 from 2001-2020, it was found that the perfect timing of the market—buying the full $2,000 worth of stock at the yearly lows also known as buying the dip—does indeed return more than any other strategy such as dollar-cost averaging—but surprisingly not by much. Compared to the investor who immediately invested their $2,000 at the beginning of each year, the perfect market timer only left with about a 10% larger return by the end of the 20-year experiment. Lastly, compared to the investor that invested their $2,000 at the worst time of every year—when the market was at its yearly high—the perfect-time investor beat them by just about 20% by the end of the 20-year test. So, yes, if you can perfectly time the S&P 500, then you do actually have a margin to yield higher returns. But, is timing the market realistic? Charted below is the S&P 500 index from 2010 – 2016 with annotations from various investors calling for a bear market or crash, essentially trying to time the market. Even to professionals, knowing when the market will go up or down is not possible. By listening to these predictions, investors also run the risk of missing out, which is the worst-case scenario. Thus, how should one approach the S&P 500? Well, if investors can not time the market, it brings us to the second-best strategy; investing as soon as you receive the capital.
At the end of the day, buying the dip is a strategy that can be utilized on individual stocks or market-wide indexes or funds. Buying the dip in companies is not always a good idea, as it is often fundamental risks that pose risks to the company’s future that cause large falls in stock price. With careful evaluation based on information that sometimes may not even be available, investors should take extreme caution with individual companies. On the other hand, buying the dip on the S&P 500 may tell another story, as its historically safe and successful returns provide a safety net to investors, no matter when they invest. Ultimately, buying the dip in the S&P 500 can provide the possibility for more alpha–returns that exceed the market average–though timing the market is not realistic, and thus, when facing the S&P 500 investors should invest as soon as they receive their capital and trust the safety and reliability of the long term returns of the market.