As an investor, you always search for ways to increase your profits. Maybe that’s finding a company poised for a breakout (think Nvidia before the start of 2023). Or it could simply be finding a company with strong financials but whose price has pulled back a little, also known as when you “Buy the Dip.”
Seizing the opportunity to ‘buy the dip’ is a strategy that empowers you as an investor. In this article, we’ll delve into what it means to ‘buy the dip’ and equip you with the knowledge to identify companies that could offer a profitable opportunity.
Buying the dip is a common investing strategy in which someone purchases shares of a company after its price has dropped. Often, investors feel this is a short-term pullback in the stock price, and they’re buying the dip before the price continues going higher.
However, it’s important to understand that you can’t implement this strategy in any company. For things to work out, you want to look for companies with strong fundamentals, great leadership, and a robust business model. When people sell shares of these companies, it’s usually because they’re taking some of their profits, not running from a failing business. When the price pulls back on these companies, it can be a great time to add to your position.
When Should You Buy The Dip?
While some might think the best time to buy the dip is when a stock price has fallen significantly. However, that’s not exactly true. You should only consider buying the dip when the price has fallen, but the fundamental values remain unchanged.
So what exactly does that mean? You never want to invest in companies that don’t have strong fundamentals. The decrease in stock price needs to be due to reasons unrelated to the company’s health. Here are some things that can cause a pullback when it would be a good time to buy the dip.
Systemic Risk
The best opportunity to buy the dip happens when the market has systemic risk. This means the market as a whole is dropping because investors are selling their positions across the board. This is frequently the case when the stock market is in a bear market, or one particular industry sees a lot of selling pressure.
Unwarranted News
It’s not uncommon for people to sell the news. This means when something negative comes out about a company, big or small, they get scared about the effects it will have, and they sell their position. Depending on the news, this can lead to a buying opportunity.
Before making a decision, ask yourself some questions. Does the news give you some concern about the company’s long-term prospects? Do you think the news was an overreaction to something? Depending on your answers, you could decide that based on the company’s price decline, there is an opportunity to profit from the negative news.
How Do You Buy The Dip?
Buying the dips isn’t about being able to time the market. It’s nearly impossible to know when a stock is going to bottom and start making its rebound. If you try to time the market, it’s almost guaranteed you’ll lose money. Don’t forget you’re buying the dip for the long term. The idea isn’t about buying and selling quickly for a profit. You’re looking to enter into a position or add to your existing position at a discount.
Looking at the big picture, if you spot companies that have declined 20% and entered bear territory but meet your criteria for buying, then it’s a good time to invest. You can also look at smaller pullbacks as an opportunity. For example, maybe Wall Street got spooked by news affecting an entire sector, and a company you’ve been watching declined by 5%. You could buy that dip.
Then, if it declines by another 3%, you can buy the dip again. This allows you to dollar-cost-average your way into a position. But don’t forget that the company needs good fundamentals that outweigh the negatives for long-term success.
Bonus Tip: Use a free portfolio tracker like Ziggma to understand how added positions will affect your overall portfolio.
Pros and Cons of Buying The Dip
Before buying the dip, consider the pros and cons of investing with this strategy.
Pros
- You’ll be able to lower your average share price, creating a larger overall return.
- You’ll be rewarded psychologically knowing you bought shares at a discount.
Cons
- Buying the dip is the same as timing the market, which can be a risky way to invest
- It’s not guaranteed that the share price will go up.
- If you’re waiting for the price to dip and it doesn’t, you could miss out on gains.
Buying the Dip Example
One of the best examples of buying the dip happened during the 2007-2009 financial crisis. The S&P 500 fell 56.8% from its peak on October 9, 2007, to its bottom on March 9, 2009.
Because Wall Street was so spooked by the health of the banking and financial sectors, the market dropped fast and sharp. This presented a buying opportunity for companies with strong fundamentals, and many people took advantage of this opportunity. In 2009, the S&P 500 ended up by 25.94%. While the market was still down significantly from its 2007 peak, many people made a lot of money by buying the dip.
Another great example would be during COVID-19. The S&P 500 declined by 34% due to fear about what the pandemic would do to the world’s economies. While COVID significantly affected GDP, creating a temporary concern for many companies’ fundamentals, it also presented a great buying opportunity. Since the world reopened, the markets have seen tremendous gains.
How to Manage Your Risk When Using The Buy The Dip Strategy
If you decide you want to buy the dip on companies, there are a few tips you can follow to increase your likelihood of success.
Determine When You Want To Invest
First, you need to decide when you’re willing to put your money to work. For example, if you’re looking to buy the dip once a company’s share price has dropped 5%, be ready to purchase at that point. Don’t wait for further declines because you could miss your opportunity. Remember, this isn’t about market timing.
Understand The Consequences of Having Money On The Sidelines
Even though buying the dip can create profitable opportunities for investors, it’s important to understand any potential consequences. By keeping money on the sidelines, you’re potentially missing out on favorable tax savings and your ability to earn dividends.
The Bottom Line
When buying the dip, the goal is for long-term investors to take advantage of price declines. When stock prices fall but there is still underlying value in the company, this is a great opportunity for many investors. However, using the buy-the-dip strategy isn’t about timing the market so you can then sell high. Instead, it’s a way to enter a position at a lower price so you can increase your potential return.