Buying on the Dips
Commentators often advise stock investors to “buy on the dips.” Jason Zweig took a detailed look at this advice and came up with the counter-intuitive result that buying on the dips doesn’t work.
This result is a tough sell, though. It just seems obvious that we’re better off buying stock just after a 5% drop than just before. What many investors don’t realize is that this is a false comparison. To be able to buy on a dip, you must have cash available that is designated for stock ownership but isn’t yet invested.
The next thing to consider is that you must keep this money available for as long as it takes to get to the next dip in prices. What if stocks rise 40% before the next 5% dip happens? You’re better off buying at 35% higher prices than 40% higher prices, but buying right at the beginning before the 40% rise is the best option of all here.
The fundamental problem with buying on the dips is the opportunity cost of holding cash that is not getting stock returns. Having cash on the sidelines works well sometimes, but works out poorly more often.
This result is a tough sell, though. It just seems obvious that we’re better off buying stock just after a 5% drop than just before. What many investors don’t realize is that this is a false comparison. To be able to buy on a dip, you must have cash available that is designated for stock ownership but isn’t yet invested.
The next thing to consider is that you must keep this money available for as long as it takes to get to the next dip in prices. What if stocks rise 40% before the next 5% dip happens? You’re better off buying at 35% higher prices than 40% higher prices, but buying right at the beginning before the 40% rise is the best option of all here.
The fundamental problem with buying on the dips is the opportunity cost of holding cash that is not getting stock returns. Having cash on the sidelines works well sometimes, but works out poorly more often.
@MJ: Opportunity cost is almost never considered by investors.
ReplyDeleteThis has also been an issue for investors who moved their fixed income investments to GICs or cash because "interest rates are guaranteed to rise and bonds will lose money."
We're still waiting for that to happen. Meanwhile XBB is up over 6& annually over the last three years. No one earning 1% or 2% on the sidelines ever thinks of this as a loss, but it is.
@Dan: You make a good point that opportunity cost applies to fixed income as well as stocks.
ReplyDeleteHow about re-balancing your portfolio after a dip in stocks?
ReplyDelete@Chris B: Since rebalancing is for controlling volatility, I see no problem with rebalancing after stocks drop (or rise sharply for that matter). This is different from holding cash on the sidelines hoping for prices to drop.
ReplyDeleteDale has a point, but it seems like he's talking about a different type of situation than what Michael and Zweig are talking about, where the investor waits in cash for a buying opportunity.
ReplyDeleteI, like Dale, imagine a situation where you raise some money by selling a stock you feel is more expensive to buy one you feel is less expensive. Seems similar, but different.
Michael, on a different subject, you may want to register your site at tiptheweb.org. I sent you a 50 cent tip on one of your earlier posts. Perhaps if you make others aware of Tip the Web, you may get a few more appreciative tips. Perhaps even working your way up to PAPER MONEY!
@Gene: I agree that selling one investment for another is different from "buying the dips".
ReplyDeleteI'll check out tip the web.
@Michael: I do agree with you despite evidence to the contrary. I'm reminded of the strategy of buying more US and international stocks when the Canadian dollar is "high". The flaw here is that the crystal-ball investor would buy US assets not when the Canadian dollar is higher than in the recent past (say, when it's above parity), but rather when it will be lower in the future.
ReplyDeleteThe trouble is that the strategy has won out despite its flaw because "above parity" and "will soon drop" have been correlated perfectly in the last decade or so.
@Patrick: It's true that just about any strategy will have periods of success. The closer a strategy is to being as good as the "do nothing" strategy, the longer the periods when it will outperform.
ReplyDeleteYes, sometimes such things sounds good, but you can wait an awfully long time for a stock to dip.
ReplyDeleteI just try for a reasonable price when I buy.
I think it can still be useful advice. For example, I had some extra money in my savings account that was there for a reason unrelated to my investment strategy. However, given the big drop I decided that I would move it into the stocks, versus doing something else with it. But I agree that sitting around with a pile cash on the sidelines just waiting for a drop is bad advice.
ReplyDelete