When reading financial advice and you see the words ‘buy the dip’ it is best to stop reading. This is not good advice if you are doing anything other than a buy and hold strategy. For many, a buy and hold strategy is not the most effective investment strategy. It’s just the easiest.
Back to buy the dip. If something is less expensive than it was yesterday, last week or last month, does it make it better quality? No it doesn’t, it just makes it cheaper.
Buy the dip is used in the context of buying stocks and other finance products. It is one of those catch phrases that sounds good. It is easy to understand. Hence the attraction for financial commentators to use it often when speaking about investing.
One of the mistakes is trying to guess the direction of the stock.
The premise is, you are reducing the cost base per stock. The cost base being the price you pay for each individual stock. The flip side is that you have to spend more money to reduce that cost base. As with everything there is a risk. If you buy on a dip and it continues to drop then the phrase ‘throwing good money after bad’ is just as catchy.
Let’s look at the following:
Price per stock
Total price for 100
$50
$5 000
Price drops so you buy some more because you have been told to buy the dip.
Price per stock
Total price for 100
$40
$4 000
Therefore you own 200 for a total cost of $9 000 giving a price per stock of $45. You have reduced the original cost base per stock from $50 to $45. Great. Now they only need to rise back up to more than $45, rather than $50 for you to make a profit.
Of course stocks don’t always go up, nor is that guaranteed. They may have dropped from $50 to $45 because of some long term problem. So they continue to drop. Say to $30.
Original cost (100 x $50)
Sale price (100 x $30)
Loss on sale
$5 000
$3 000
$2 000
Or,
Original cost (200 x $45)
Sale price (200 x $30)
Loss on sale
$9 000
$6 000
$3 000
If you had not adopted a buy the dip strategy then your loss would be $2 000. Now because you bought more, the loss is $3 000. The buy the dip strategy resulted in an extra $1 000 loss.
One of the mistakes is trying to guess the direction of the stock. If you could be 100% certain the price will increase, a buy the dip strategy makes sense. Problem is that is not possible using publicly available information.
I haven’t even mentioned the opportunity cost of putting the $4 000 used to buy the second lot into something that was already showing an upward trend rather than a downward one.
- Would you rather go to a casino and gamble or buy the dip and do the same thing?
- If you have profited from a buy the dip strategy, was it guaranteed to go up?