Should you buy on the dip?

It was another tough October for investors, with the S&P 500 and the S&P/TSX Composite Index both falling by a little more than 6%. At one point during the month the S&P 500 fell by close to 10%, putting it into correction territory. Most fund managers and investment experts would have said to buy on the dip—it’s something they’ve been saying to me for years. It’s the essence of buy low, sell high and it’s especially useful when the market declines by 10% or more, or so they say. But does it work? And is it a feasible strategy for the average investor?

While buying on the dip sounds like a good strategy, people forget that it’s just another form of market timing and study after study has shown that timing the market is nearly impossible to do. One problem is that you never know when the market will rebound. If you bought the dip in 2008, you would have invested on June 26, when the S&P 500 was down by about 11% on the year. With stocks continuing to fall until March 9, 2009, you would have lost another 47% until things started turning around.

Plus, while stocks tend to rise over the long-term, they don’t climb in the way the S&P 500 did after its market trough in March 2009. (You’d be up 302% if you bought in on the 9th.) Between September 3 and October 14, 2014, the S&P/TSX Composite Index fell by more than 10%. It’s up just 7% since, but only after experiencing numerous ups and downs over the last four years.

Eric Kirzner, a professor of finance and the John H. Watson Chair in Value Investing at the Rotman School of Management, is at least one investment expert who does buy into the buying on the dip adage. “It’s not a strategy,” he says. “10% could turn into 20%.”

Need more cash

There’s a reason why fund managers say they buy the dip: they have the cash to do it. Many managers have cash reserves of a few percent to up to 60%, depending on the style they follow. When the market falls by 10% they can invest some of that money in the hopes that equities will start rising again. Even then it’s not a proven strategy—the majority of active managers don’t beat their benchmarks. In any case, the average person doesn’t have that kind of dough sitting around and no one should deplete their emergency fund to buy stocks on a drop.

Last year, Samuel Lee, founder of SVRN Asset Management, a fee-only investment advisory firm in Chicago, looked at whether buying on the dip was a sound strategy. He took U.S. market returns between mid-1926 and the end of 2016 and simulated a strategy where someone would buy in after a 10% decline and hold on for at least 12 months or until stock prices returned to pre-drop levels. They’d then go into cash and wait for the next decline.

When compared to someone who bought into the market in 1926 and held until 2016, the buy-the-dip strategy returned 2.2% annualized, while buy-and-hold returned 6.3%. He ran this same scenario using larger dips and buy-and-hold won out every time. The only time buying the dip makes sense, he says, is if the market crashes by more than 40% and you hold on for five years, but that’s a rare occurrence. Even then you’d only generate half the market return going back to 1926 and you’d be in cash two-thirds of the time. “This data does not say you should always buy and hold, no matter what,” writes Lee on his website. “It simply says that a mechanical strategy of waiting for a crash on average resulted in much worse absolute and risk-adjusted returns than buying and holding.”

Time to rebalance

Saying all this, there are two ways to take advantage of a decline. The first is that a dip provides an opportunity to rebalance your portfolio. If you have an asset allocation of 70% stocks and 30% bonds, it could go out of whack if the market corrects, says Kirzner.

If you now have a 60% to 40% portfolio, but want to get back to 70% and 30%, then you will have to put more cash into stocks or sell some bonds to buy more equities. If you’re paying attention to your portfolio, it could make sense to do that around a decline, when your portfolio’s allocation goes awry. “A lot of advisors say to rebalance every six months or a year, but that doesn’t make sense,” he says. “Instead, do it when there’s a sufficient move in either direction that puts your allocation out of balance.”

The other way this can work is if stock pickers keep a close on company valuations and buy in when the business one wants to own becomes cheap. Kirzner stresses that this is only a good idea when it comes to individual stocks. If a stock is trading at 20 times earnings and it falls to 15 times—and price-to-earnings ratio is a better metric than stock price—and you think its PE could climb again, then go ahead and put some money to work.

Don’t take this approach with the overall market, though. “Then it absolutely is market timing,” he says. “If you know a company really well and you do your own analyses and assuming you’re good at it, then if there’s a significant decline in the price of the stock then you could buy in.”

So, what you should you do the next time the market drops by 10%? Just like you wouldn’t panic sell, don’t panic buy. If you believe stocks will rise over time, then put a little money into the market every month or when you have some cash to invest. “I sure don’t feel guilty about missing buying opportunities,” says Kirzner. “I’m just happy we got a decent rebound at the end of the month.”