The problem with buying the dip

Good investing starts with understanding that markets and company shares move. They go up, they go down. It’s what they do. 

And if we’re investing, we’ve decided the risk and volatility are worth it because of the hopeful long-term outperformance of equities over cash.

Along that long-term journey we tend to pick up a few old adages here and there. “Time in the market, not timing the market” is a good one. 

"Know what you own, and know why you own it" is a cracker. And the one we’ve seen quoted to death between emojis of diamonds and hands is “Buy the dip”.

It’s that last one that’s a bit different from the others because it can be useful a lot of the time but it won’t always help. In fact it could make things worse.

Why do investors buy the dip?

The conventional wisdom behind the sentiment is built on the simple assertion that, if you’ve bought a quality asset, why wouldn’t you snap up more shares if the market offers you a bargain price?

But there’s a key part in there, the ‘quality asset’ part. And that’s important because it implies a share price fall would be out of character - at odds with the long-term slow and steady trajectory of the likes of a market leader with few competitors and strong pricing power.

Don’t rely on the dip

If we’re investing in broad index ETFs or consistent compounders then it may be that those share price falls do present near-term buying opportunities.

But waiting around for them at the expense of actually being invested in those stocks risks derailing the whole journey.

The evidence shows us that looking to the long term and staying invested through thick and thin is ultimately the best strategy. That’s because the value of compound growth works best when you leave it alone over time. Inevitably that will involve up and down periods but staying put means maintaining the snowball effect no matter what.

That means it’s not necessarily a bad thing to be buying dips, it’s how we prepare for that eventuality. In short, if we get so hung up on waiting for the falls that it distracts us from the simplicity of being in the stock in the first place, we’re bound for trouble.

Look beyond the share price

Even with a little cash on hand and top-rated assets in the portfolio, price falls are not automatic triggers for a buy. 

We need to look beyond the graphs to the businesses behind them. Examining what actually caused the falls is imperative and is a step a surprising number of investors skip.

Sometimes a buy will be justified. Like Boohoo dropping a few years ago on the news that ASOS fluffed getting its products through US customs. They’re similar companies but that had nothing to do with Boohoo and it was unfairly tarred with the same brush on the day. Looking back, it was a great opportunity to snap up shares at knock-down prices.

It doesn’t always work like that though. If price falls are the result of a serious setback to a company’s strategy, sending in good money after bad is a risky move. Shares in Covid-testing firm Novacyt bombed this month after it said it hadn’t managed to extend its NHS contract for testing kits this year.

Sales to the NHS made up 50% of Novacyt’s total revenues during the first quarter of 2021 so the partnership falling off a cliff could mean the same for sales and profits.

In both these cases there was a share price drop that made investors sit up and take notice. But taking a second to understand the reasons and how they fit with the wider narratives of the companies paint very different pictures.

Investors reassessing their theses after such a hammerblow need to understand more than just the red line on the screen.

But it doesn’t have to take such an impactful event to prompt a bit of thought. We should be regularly looking at how the firms in our portfolios are changing and, crucially, if the reason you bought in is still intact.

If it isn’t, what began as a possible top-up might actually turn into grounds for a sale.

When is a dip not a dip?

It’s easy to spot the dip after it has happened. But when you’re in it it’s impossible to know if and when it’ll end. And even then there’s no telling what a possible recovery would look like. The alphabet soup of V, U, K, W and swoosh-shaped Covid recovery predictions last year is evidence enough of that.

Again, in the moment we have to ask if there has been a fundamental change to business or if there is a route back to the trajectory the company saw before.

The next step is to ask how much more of a fall you can stomach if you choose to buy more now. Averaging down in stages might work to your advantage if the turnaround materialises but try not to get sucked into investing all the way down to zero.

If a dip turns into a freefall keep in mind that it’s better to live to fight another day than vaingloriously go down with the ship.

The overarching principle here is to look at the business underneath it all. That will help you decide whether you would be happy to ride out a period of underperformance or not.

Four tips to plan for the dip

1. Pre-mortem thinking is a good habit to develop as an investor. Ask yourself what you’d do if your company’s shares fell by 50%. What would be the likely reason for that and could your investment case withstand a setback like that?
   

2. It might be that a fall is a sign a core element of the company has changed. If it has, and your original thesis no longer holds up, it might be time to consider selling up and moving on. Again, the share price was merely a signal for you to look deeper into what’s happening underneath. Don’t get attached to a company. Remember, the stock doesn’t know you own it and sometimes you’ll have to sell on a dip to protect yourself against further falls.
   

3. Give yourself a small amount of cash to hold in case a bargain pops up. Define what that limit is, it might be 5% of your portfolio but it should never be enough to dilute gains elsewhere. If you’re waiting for a red carpet entry into a stock, it’s never going to come. It’s much better to be in there and building dividends than sitting on the side lines waiting.
   

4. Probably the best way to plan for a dip is to not. Focus your energy on investing regularly into those quality assets and growing the benefits of pound-cost averaging.

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Learn more:

How to invest in the stock market

Detailed guide to investment risk

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