Buying the dip is a legitimate investment strategy, but it can be tricky to execute and there are no guarantees that you’ll ultimately make money.
When the U.S. stock market is down (as it has been over the course of 2022), share prices generally fall. Buying stocks while their share price is down is known as “buying the dip” and could be a good investment strategy if the stock’s share price later rises to more than you bought it for.
While this may work for some investors, you should know what to look for when buying the dip. You should also determine whether or not this is a better strategy for you than other, simpler investing strategies.
What is a dip and why buy it?
Buying the dip means buying shares of a stock after the price has dropped significantly. It’s a strategy for investing money that has helped billionaire investor Warren Buffett grow his wealth.
For example, Microsoft shares were selling for just over $334 per share on Jan. 3, 2022, but as of June 13, 2022, that share price had dropped to about $242. So if you bought Microsoft shares in June, assuming the price drop would be short-lived and the stock would eventually increase in value again, you would have been buying the dip.
Why would you want to buy stock shares in a dip? The same reason you would buy an item on sale — it’s a discount, so your money goes further. Everyone loves a discount, right? For example, if you have $5,000 to invest in Microsoft, you’d be able to buy 20 shares in the June 2022 dip, compared to just about 15 at the January 2022 price.
When you buy the dip, you want to target stocks projected to rebound and increase in price, thus possibly earning you a nice profit. Say you bought 20 Microsoft shares during a dip at $242 per share, which is about $4,840. If the stock rebounded to $334 per share, you would make a return of about $1,840 on your investment.
How to buy the dip?
Although it sounds somewhat easy, making money off buying the dip takes strategy. You have to time the market so you know the right time to buy a stock and the right time to sell it.
Successful market timing takes a fair degree of luck, but there are some things you can do to increase your chances of making a profit.
Watch the market trends
A number of factors influence the fluctuations of stock prices, including a company’s quarterly earnings report, national politics, Federal Reserve interest rates, and the overall economy. Before you buy the dip and invest in a stock, watch trends in the market and see how the stock is performing. What’s the stock’s moving average? How has the stock been performing over the last hour, week, or month?
The share price may have dropped to a historic low, but it could go even lower, so you don’t necessarily want to buy shares when they first start a downward trend. It’s when the share price starts to trend up that it may be a good time to buy the dip.
Use an indicator or a predictive model
When you want to buy the dip, there are several indicators to pay attention to that could help you decide what stocks to buy and when. These indicators include a stock’s volume, momentum, and price trends.
You can also use predictive modeling to forecast how the stock may do in the future, based on historical data. Stocks that may have better returns for long-term investors are better options when buying the dip than those that may be profitable only in the short term.
Put limit orders to secure your price
A limit order enables you to set the price you’re willing to accept to buy or sell a stock. The limit order will only be executed when the market price of a stock reaches the price you’ve set. For example, if a stock is trading at $5 per share and you place a limit order for $3.50, then your order is automatically executed if the share price drops to $3.50.
Adopt dollar-cost averaging
Dollar-cost averaging is a strategy you can use when buying the dip. It involves buying a stock at different intervals during its price fluctuations rather than buying it all at the same price. For example, if you spent $3,000 on 150 shares at $20, then the stock price rose to $30 per share, your profit would be $1,500.
With dollar-cost averaging, also called averaging down, you would buy 50 shares at $20 each, then another 17 shares when the price drops to $15 each, and another 24 shares when it drops to $11 each. So if the stock price increased to $30 per share, your profit would be closer to $6,240.
Is buying the dip a good investing strategy?
Buying the dip can be a good investing strategy if you play it right. Day traders may buy the dip and then turn around and “sell the rip” when the stock price increases again. However, hanging onto the stock long term may prove more profitable.
TipYou’ll likely have better success buying the dip if you see it as a long-term investing strategy rather than a get-rich-quick scheme. Use the stock market lows to buy stock in companies you think may be profitable once the market stabilizes.
Looking at the earlier example of Microsoft stock, Microsoft has an annualized return of 25.51%, which is above the 10% historic average annual rate of return for the stock market. This indicates that Microsoft stock may have a better chance of earning a profit once its stock price goes on an uptrend.
Pros of buying the dip
If you play the game right, there could be several advantages to buying the dip.
Earn higher returns
Because you’re buying stock during a dip period when you can get a lower price, there is a chance that you’ll make a nice profit if the price goes on an uptrend and you can sell your shares at a higher cost.
Reduce cost basis
The original value of a stock is called its cost basis, and it's used to calculate capital gains taxes. Buying a stock when its price has dipped reduces its cost basis, which means you could buy more shares for less money and give yourself more room for potential profit.
Keep in mind that cost basis affects how much you’ll have to pay in capital gains taxes if or when you sell your shares. The lower the cost basis and the higher the sale price, the higher the taxes you’ll have to pay. Capital gains taxes are also affected by the length of time you hold onto a stock. If you hold a stock for less than one year, you’ll pay a higher capital gains tax rate.
Beat the market performance
The S&P 500 Index, which has a historical average return of about 10%, is considered a performance benchmark against which the rest of the stock market is judged. Investors who earn higher returns than this threshold are considered to have “beat the market.” If you manage to earn high returns buying the dip, then you could potentially beat market performance.
Cons of buying the dip
Buying the dip isn’t for everyone, and investors should be wary of the disadvantages of this strategy.
Timing the market is unpredictable
Stock market volatility makes it difficult to time the market. Your move to buy the dip may not ultimately pay dividends. Even the most experienced investors have a hard time predicting the ups and downs of an erratic stock market.
Recoveries might be slow
Buying the dip should never be seen as a get-rich-quick scheme. You only make money if stock prices rebound to their previous prices or beyond, which could take some time (if it happens at all).
Time out of the market might be costly
“Time in the market is better than timing the market” is a popular investing adage. Time in the market matters if you want to make money on your investments. Leaving your assets where they are during a volatile stock market could still give you a higher return over the long term than trying to time the market and buy the dip.
Each day your money isn’t invested could cost you thousands of dollars. A 2021 study by Fidelity showed that $10,000 invested in the S&P 500 between Jan. 1, 1980, and March 31, 2021, grew to $1.09 million. However, by missing out on just five of the best days on the market, that nest egg would shrink by 38%.
Alternative investing strategies
Buying the dip can be profitable, but it is risky and requires a higher knowledge of investment fundamentals to pull off. Here are a few portfolio protection strategies you may want to consider as an alternative to buying the dip.
Diversify your portfolio
Diversifying your portfolio with several different types of investments is a good way to reduce risk in investing through allocation. With diversification, if one or more of your assets are down, it has less impact on the overall performance of your portfolio than if you put all your eggs in one basket.
Invest in ETFs
An exchange-traded fund, or ETF, enables you to invest in several companies without buying individual shares in each one. An ETF is a basket of securities that are owned by multiple investors. You can buy ETFs for stocks, bonds, commodities, currency, and even specific sectors.
Add non-correlated assets
Non-correlated assets in the U.S. aren’t impacted by the ebbs and flows of the stock market. These assets include gold and other precious metals, real estate and real estate investment trusts (REITs), commodities like energy and agricultural goods, and foreign currencies.
Use government bonds
In a time of rising inflation, government bonds like TIPS (Treasury Inflation-Protected Securities) and I Bonds may be a good investment because they are linked to the Consumer Price Index (CPI), which tracks the rate of inflation.
The value of these government bonds increase when inflation increases. Government bonds are also generally considered a more stable investment than stocks.
FAQs about buying the dip
When should you buy the dip?
It’s hard to pinpoint precisely when a good time to buy the dip is because it all depends on timing in the market. Buying a stock at what looks to be its lowest price in years, only for its price to drop even lower after you buy it probably isn't a good financial strategy.
Using a dollar-cost averaging approach, you can invest in a stock at different stages as it declines, so you could potentially earn a nice profit if it does rebound.
Should I buy stocks when they are low?
Many investors, including billionaire Warren Buffett, use the "buy low, sell high” dip strategy. However, bargain-priced individual stocks may take some time to regain their value. If you are willing to wait for a stock to (hopefully) rebound and increase your profits over the long term, buying stocks when they are low may be wise — but there are no guarantees.
How long do you have to hold stock to avoid short-term capital gains tax?
You must hold a stock for at least one year to avoid short-term capital gains tax. Capital gains tax kicks in when you sell your stock and make a profit on that sale. So if you bought a stock in the dip at $20 per share, then that share price eventually increased to $50, you’d be taxed on the $30 profit if you sold it.
There is no time limit to capital gains tax. It applies whenever you sell the stock, regardless of whether it's been 10 months or 50 years. But if you hold a stock for less than one year, you’ll be taxed at the higher, short-term capital gains rate.
When the stock market is low, you may consider buying the dip in share prices. Although buying the dip could help you eventually reap higher returns, it may take awhile, and there’s no guarantee the strategy will work. Investors who want to buy the dip should know how to invest in stocks and how to gauge the market.
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