When stocks fall, many investors run for cover while others look for bargains and “buy the dip.”
Buying the dip means investing in stocks after they’ve lost value, picking them up “on sale”
with the expectation they might not only bounce back but hit new highs, resulting in a profit.
While looking for bargain investments is nothing new, buying the dip was a mantra
for many investors when stock prices plummeted during the COVID-19 pandemic.
Investors started buying in March, and by June, the Dow Jones Industrial Average® had rallied
almost 48%, a boon to anyone who bought the dip. However, religiously buying the dip could come at
a cost. Sometimes investments lose value for good reason. Buying the dip could be
like trying to catch a falling knife, leading to larger losses if the price keeps dropping.
Consider Netflix in January 2022. The company reduced its forecast for new subscribers during
the first quarter, causing its share price to plunge nearly 22%. Many investors bought the dip,
prompting a rally. But it was short lived, and the stock continued to fall for the next four months.
So, how do you find stocks on sale while avoiding falling knives? It’s impossible to be right all
the time, but there are some strategies you can follow to improve your chances and manage risk.
First, if you see a stock fall to an appealing price, make sure you’re still making a sound
investment. This starts with analyzing the company to ensure that whatever drove
the stock price lower hasn’t fundamentally changed the way the company does business.
For example, if a stock drops after a competitor releases a new technology that
makes the company’s major product obsolete, you may want to reconsider investing. Do you
remember Kodak? It ignored the digital camera revolution and nearly went the way of the dodo.
But if the news is something temporary, like a one-time unexpected expense that hurt quarterly
profits, then it could be time to buy the dip. Also, be careful how much money you’re putting
into a particular investment, so you remain diversified. If you’re creating a new position or
adding to an existing one, a common guideline is to keep it at just 3% to 5% of your portfolio. A
larger position could become a major risk because a price decline could result in a large loss.
Finally, consider looking at the stock’s chart to ensure the long-term trend is still intact.
Technical analysts believe the trend is your friend, so tread carefully if the stock has broken
a major support level. While breaking support doesn’t guarantee that a stock won’t recover,
trading with the trend may improve your odds. Timing market dips can be tricky. If you’re a
longer-term investor, dollar-cost averaging is a more systematic stock-buying approach to consider.
That means continuously investing the same amount of money in a security over time,
regardless of fluctuating prices, rather than the entire amount all at once.
For example, if you wanted to invest $1,000 in a stock that’s currently trading at $50 per share,
you could break it into five increments of $200 and purchase shares at regular intervals.
Let’s say you were able to buy at $50, $48, $47, $51, and $52 over a five-week period.
Your average price per share would be $49.60, saving you $0.40 per share.
However, there are risks. If the stock price rises over time, you’ll pay a higher average price per
share. You’d also be missing out on gains if you’d invested the full amount at the beginning.
Frequent dollar-cost averaging may generate additional trading costs,
commissions, and other transaction fees, which could outweigh the benefit.
Whatever your approach is to “buying the dip,” have a plan that defines
when you’re going to buy and how much to invest in the trade. It
can go a long way toward managing risk and sticking to your goals.