Home > Uncategorized > Buying On Dips Not A Good Idea?

Buying On Dips Not A Good Idea?

September 26, 2011 Leave a comment Go to comments

Jason Zweig’s recent WSJ article points out that buying more stocks when prices drop may not be a wise strategy if they rose so much before that the prices are still at a high level. In effect the common advice to “buy on dips” may be misguided. The market can and often does drift slowly in one direction until a sharp move gets headlines.

The argument is right. If you can buy before the initial rise that’s better than buying after the small dip that follows. But that depends a lot on the options and knowledge you have at the start. Taking his example based on the last 10 years, you couldn’t take everything you invested over that time and put it in as a lump sum at the start of the decade. Even if you could, you didn’t go into it knowing what stocks would do. And if you keep some capital out of one stock market that doesn’t mean it has to be in cash. It could go to other less correlated markets, to bonds, or to other defensive but productive assets. Even buying gold 10 years ago would have had good results.

As an example, at the start of the year I thought that stock markets might be just a little above fair value and held a small bond allocation to protect against and profit from possible drops. That bond index has returned over 7% since the start of the year while stocks have had a good series of declines which makes me lucky. But that’s just what actually happened. If you asked me then I would have guessed at further gradual increases in stock prices and falling bond prices. In that case if prices rose until now and then had one 5% drop, it wouldn’t make sense to buy more stocks because I could have gotten a better deal by having more in stocks at the start of the year. Without knowing which of those scenarios will happen we have to be prepared for both.

The other side is that buying before the increase doesn’t do you much good unless you can also sell before the market returns to its original level. This won’t happen all the time, but in a period such as the late 90s you could buy early and then have prices go up. But if you just held on and did nothing, they would soon fall back to their original level or below. Whenever there are unsustainable increases I would prefer to do some selling on the way up to actually keep some of the gains.

As the article illustrates, the important thing is not to think that a dip in prices means they are cheap. You need to look at the bigger picture. If the stock market hits a P/E of 25 and then has a 3% drop I’m not going to rush out and buy more because I’m not confident going all out on an investment with an earnings yield of 4%. What I like even more than a nice 5% drop is a headline raising alarm about how much the market has dropped in the last 3 months. Since I don’t watch the market daily all kinds of headlines can be a useful reminder to check where it’s at now.

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