Wait for the dip, or keep buying?

Feel free to reach out to PSG Wealth Manager  Armand De Beer  directly.

Imagine for a moment that you have just inherited money, received a year-end bonus or an income tax refund. You need to decide whether to invest now or wait. You might face this kind of decision every year – sometimes in bull markets, other times in downturns. Is there a good strategy to follow?

You have probably heard of the strategy ‘buy the dip’ (BTD for short) – a piece of advice that social media influencers have promoted. There is so much spotlight on BTD that the old strategy of phasing funds into the market, or so-called ‘dollar-cost averaging’ (DCA for short), has been overshadowed. Is BTD a better long-term strategy?

Buying the dip vs. dollar-cost averaging

Note: The analysis and examples shown here were done on the S&P 500 Index. You can generalise it to any asset class expected to have a positive long-term return.

In an educational piece about the comparison between the dollar-cost averaging and buy-the-dip strategies, Kelvin Lee (Standard Chartered, Associate Director and Senior Investment Adviser) used the following example to compare the two strategies: 

You have $100 monthly to invest in the S&P 500 Index for the next 15 years, from January 2007 to December 2021. You have the following two investment strategies to choose from:

1. Phasing funds into the market each month: You invest $100 in the S&P 500 Index every month for 15 years (also referred to as dollar-cost averaging in this example, or DCA).
2. Buy the dip (BTD) when the market drops by 10%, 20%, or 30%: You save $100 cash each month until the market falls by 10% from its previous highs. Then, invest all the saved-up cash in the S&P 500 Index. Continue saving $100 cash each month and invest everything again when the next 10% dip occurs. The same process applies to the 20% and 30% dips.

Figure 1 below illustrates the hypothetical points of investment using the 10% BTD strategy.

Figure 1: Source: Dollar Cost Averaging or Buy the Dip? - Standard Chartered. https://www.sc.com/sg/wealth/insights/dollar-cost-averaging-or-buy-the-dip/

The various entry points for buying the 10% dip (red arrows), 20% dip (yellow arrows), and buying the 30% dip (green arrows) are shown in the chart below.

Figure 2: Source: Dollar Cost Averaging or Buy the Dip? - Standard Chartered. https://www.sc.com/sg/wealth/insights/dollar-cost-averaging-or-buy-the-dip/

Findings from the comparison: monthly contributions outperformed buy the dip

Investing funds in the market every month (or DCA) earned the best results in dollar amount profits. The amounts invested under BTD strategies were noticeably reduced as you sat on cash while waiting for the market to drop further. Investors had fewer opportunities to buy the more significant dips simply because those drawdowns did not materialise.

The table below shows the findings from the study.

Table: The dollar amount of investments, market value, and profits. Source: Dollar Cost Averaging or Buy the dip? - Standard Chartered. https://www.sc.com/sg/wealth/insights/dollar-cost-averaging-or-buy-the-dip/

In his book, Just Keep Buying, finance blogger Nick Maggiulli crunched the numbers to demonstrate why he thinks you should not wait to buy the dip. He makes the case that buying the dip will only sometimes work in your favour. His findings show that consistently buying whenever possible is the best investment method.

Magguilli studied the S&P 500 Index from 1920 to 2020 and looked at 20-year-interval periods. His research highlights the primary issue with a BTD strategy: it holds cash for far too long. And while you sit on cash, the market tends to go higher. As a result, you buy at much higher prices later than if you had just purchased from the start.

For example, imagine deciding to wait to buy until there is a 20% dip in the market. What if the market doubles without any such dip? Even if the market were to dip 20% from there immediately, prices would still be 60% above where they were when you started investing. Therefore, when you buy the dip, you end up buying not at a 20% discount but at a 60% premium!

Is waiting for a 50% dip better or worse than waiting for a 10% dip?

As Magguilli's research shows, the larger your dip threshold, the more likely you are to outperform DCA over some random 20-year period between 1920 and 2020:

Source: Why Buying the Dip is a Terrible Investment Strategy (https://ofdollarsanddata.com/why-buying-the-dip-is-a-terrible-investment-strategy/)

This chart shows a roughly one in four chance of beating DCA using a BTD strategy with a 10% to 20% dip threshold. Suppose you were to use a 50% dip threshold: the opportunity of outperforming DCA increases to nearly 40%. But this comes with a cost: while you are more likely to outperform DCA when using a more significant dip threshold, you underperform by more (on average).

If you had looked at all 20-year periods from 1920 to 2020 and had followed BTD with a 10% dip threshold, you would have underperformed DCA by about 5%. If you had used a 50% dip threshold, you would have underperformed DCA by about 13%.

Source: Why Buying the Dip is a Terrible Investment Strategy (https://ofdollarsanddata.com/why-buying-the-dip-is-a-terrible-investment-strategy/)

Savvy investors may still prefer a BTD strategy if they have a constructive view of an asset after conducting their own fundamental or quantitative analysis. They may establish a fair value price for a particular security and are therefore comfortable accumulating more on further price weakness.

However, for most investors, it would be better to employ DCA for the following main reasons:

• It prevents procrastination: You know you should be investing but never get around to doing it. Automating your investments forces you to put your cash to work immediately and consistently.
• It reduces the emotional component: Automating your contributions is a precommitment that can help counter behavioural bias because, as the market sells off more, you start to wonder what the market is seeing that you do not. A precommitment in this environment can be a powerful way to do the right thing, even when it feels terrible.
• Avoid market timing: By regularly phasing funds into the market, you will naturally buy more shares when prices are down and fewer when prices are up. It will eliminate market-timing strategies that are challenging to follow successfully, even for sophisticated investors.

While it can be tempting to stockpile cash to buy the dip, research shows that this strategy will likely fail to win in the long run. Make use of market corrections to add additional funds to your investments. And if you happened to buy the dip once successfully, take the win, then get back to investing as soon and as regularly as possible.