Buying the Dip: What It Means and how to Approach It

A down stock market could create an opportunity for investors to “buy the dip,” which, in simple terms, is a strategy that involves investing in the stock market when prices are lower than they were at a previous time. The price, in other words, has “dipped.”

Buying the dip is a way to try and capitalize on bargain pricing and potentially benefit from price increases in the future. But like any other investing strategy, buying the dip involves some risk, as it’s often a matter of market timing. Knowing when to buy the dip (or when not to) matters for building a solid portfolio while managing risk.

What Does “Buying the Dip” Mean in the Stock Market?

As noted, to buy the dip means to invest when the stock market is down, anticipating that values will go back up. A dip occurs when stock prices drop below where they’ve previously been trading, but there’s an indication or expectation that they’ll begin to rise again at some point.

This second part is crucial; if there’s no expectation that the stock’s price will bounce back down the line then there’s little incentive to buy in.

Why Do Stock Dips Happen?

Stock market dips can happen for various reasons, including a macroeconomic downturn, unexpected geopolitical events, or general stock market volatility that causes stock prices to tumble temporarily on a broad scale.

For example, in early 2022, the stock market fell from all-time highs for several reasons, including high inflation, tighter monetary policy, and the economic fallout from the Russian invasion of Ukraine. Accordingly, the S&P 500 Index fell nearly 20% from early January 2022 through mid-May, 2022, flirting with bear market territory.

Stock pricing dips can also be connected directly to a particular company rather than overall market trends. If a company announces a merger or posts a quarterly earnings report that falls below expectations, those could trigger a short-term drop in its share price.

What Is the Potential Upside of Buying the Dip?

Many investors buy the dip because it may help increase their returns. But again, it’s not without risks. Buying the dip is, effectively, a form of buying low and selling high. If, that is, everything shakes out in the investor’s favor.

When you buy into a stock below its normal price, there is a potential — but not a guarantee — to generate returns by selling it later if prices rebound.

Example of Buying the Dip

A hypothetical example of buying the dip could play out like this: Company A releases a quarterly earnings report that does not live up to expectations. As a result, its share price falls 5% on the day that report is released. But some investors have a hunch that Company A’s stock price will increase in the coming days, and buy shares at a reduced price.

Share prices do rebound, increasing 10% over the next few days. Investors who bought at the dip sell, and reap a positive return.

As for a real-world example, the market experienced a larger dip and recovery during the spring of 2020 connected to economic fears surrounding the coronavirus pandemic. The S&P 500 Index declined about 34% in a little over a month, from February 19, 2020, to Mar. 23, 2020. The index then experienced a gradual rise, recouping its losses by August 2020 and increasing 114% through January 2022 from the March 2020 low.

If an investor bought at the lower end of the stock market crash, they would have seen substantial gains in the subsequent rally.

On an individual stock level, and as another hypothetical, say you’ve been tracking a stock that’s been trading at $50 a share. Then the company’s CEO abruptly announces they’re resigning, which sends the stock price tumbling to $30 per share as overall investor confidence wavers. So, you decide to buy 100 shares at the $30 price.

Six months later, a new CEO has been installed who’s managed to slash costs while boosting profits. Now that same stock is trading at $70 per share. Because you bought the dip when prices were low, you now stand to pick up a profit of $40 per share if you sell.

The potential to earn big gains is what makes buying the dip a popular investment strategy for some people.

Risks of Buying the Dip

For any investor, it’s important to understand what kind of risk you’re taking when buying the dip. Timing the market is something even the most advanced investors may struggle with, as it’s impossible to predict which way stocks will move on any given day.

Understanding technical indicators and what they can tell you about the market may help, but it isn’t foolproof.

For these reasons, knowing when to buy the dip is an inexact science. If you buy into a stock low and then are able to sell it high later, then your play has paid off. On the other hand, you could lose money if you mistime the dip or you mistake a stock that’s in freefall for one that’s experiencing a dip.

In the former scenario, it’s possible that a stock’s price could drop even further before it starts to rebound. If you buy in before the dip hits bottom, that can shrink the amount of profits you’re able to realize when you sell.

In the latter case, you may think a stock has the potential to recover but be disappointed when it doesn’t. You’ve purchased the stock at a bargain but the profit you’re able to walk away with, if anything, may be much smaller than you anticipated.

3 Ways to Manage Risk When Buying the Dip

For investors who are interested in buying the dip, there are a few things to keep in mind that may help with managing risk.

1. Research Why the Stock or Market Dipped

First, it’s important to understand how market volatility may impact some sectors or industries over others.

For example, take consumer staples versus consumer discretionary. Staples represent the things most people spend money on to maintain a basic standard of living, like food or personal hygiene products. Consumer discretionary refers to the “wants” people spend money on, like furniture or electronics.

In the event of a recession, people spend more on staples than discretionary expenses, so consumer staples stocks tend to fare better. But that may create a buying opportunity for discretionary stocks if they’ve taken a hit. That’s because as a recession begins to give way to a new cycle of economic growth, those stocks may start to pick back up again.

2. Focus on Strong, Long-Term Investments

Next, consider the reasons behind a dip and a company’s fundamentals. If you’ve got your eye on a particular stock and you notice the price is beginning to slide, ask yourself why that may be happening.

When it’s specific to the company, rather than something general happening across the market, it’s important to analyze the stock and try to understand the underlying reasons for the dip, as well as how likely the stock’s price is to make a comeback later.

3. Use Limit Orders to Avoid Overpaying

Limit orders are a type of order that allow investors to automate a stock purchase or sale at a designated price, typically, at a specific maximum or minimum price. In effect, an investor can designate a maximum price at which they’re willing to buy a stock, and a minimum price for which they’d sell, depending on the type of limit order they’d use.

As it relates to buying the dip, investors can use limit orders for down-market conditions. If the price of a stock is dipping, investors can set a limit order to execute when it reaches a price at which they want to buy. Or, if they’re holding a stock, the minimum at which they’d want to sell.

Note, however, that limit orders don’t necessarily guarantee that an order will be executed. So, keep that in mind.

Is Buying the Dip a Good Strategy for Beginners?

Buying the dip has the potential to reap returns for investors, but it may not be a good strategy for beginners. That’s because, as noted, it’s a risky strategy. What investors are doing, when it comes down to it, is trying to time the market. And since nobody knows what’s going to happen in the future, that’s more or less impossible.

However, as investors become more experienced and recognize certain indicators or market trends, they may be able to make more informed decisions regarding a “buy the dip” strategy. That’s not to say they’ll become good or successful at it, but they’d likely better understand the risks and potential payoffs of trying it.

Buy the Dip vs. Dollar-Cost Averaging

Buying the dip is more of a hands-on, active trading strategy, since it requires an investor to actively monitor the markets and read stock charts to evaluate when to buy the dip or when to sell. If an investor prefers to take a more passive approach or has a lower tolerance for risk, they might consider dollar-cost averaging instead.

Dollar-cost averaging is generally an investing rule worth keeping in mind. With dollar-cost averaging, an individual continues making new investments on a regular basis, regardless of what’s happening with stock prices. The idea here is that by investing consistently over time, an investor can buy more shares when prices are low and fewer when prices are high, essentially smoothing out the ups and downs of the market when buying stock.

Example of Dollar-Cost Averaging

For example, you might invest $200 every month into an index mutual fund that tracks the performance of the S&P 500. As time goes by and the S&P experiences good years and bad years, you keep investing that same $200 a month into the fund.

You’ll buy shares during the dips and during the high points, as well, but you don’t necessarily have to actively track what’s happening with stock prices. This may be a preferable strategy if you lean toward a buy and hold investing approach versus active trading or you’re an investing beginner learning the basics.

The Takeaway

Buying the dip refers to purchasing shares at a price that is lower than a previous price, with the anticipation that values will recover and potentially overtake the previous peak. It can help investors increase returns, but as a strategy, has risks and no guarantees.

Knowing when to buy the dip can be tricky — timing the market usually is — but there are times when it may pay off for some. If investors maintain an eye on stock market and economic trends, it may help in determining when to buy the dip and how likely a stock or the market will rebound. However, it’s still important to consider the downside risks of timing the market and buying the dip.

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FAQ

How do you know when to buy the dip?

There is no way to know when it’s the right time to buy the dip. Buying the dip, as a strategy, is a form of market-timing, which is a high-risk tactic, and there’s no way to know when the market has reached a bottom, marking the ideal time to buy stocks.

What’s the difference between “buying the dip” and “catching a falling knife?”

Buying the dip refers to purchasing assets when their value has declined from a recent high. Catching a falling knife, on the other hand, refers to buying a stock that’s seen its value fall rapidly and continuously, which is an even higher-risk strategy than buying the dip.

Can you buy the dip with ETFs and mutual funds?

It is possible to buy the dip with ETFs and mutual funds, as both are exchange-traded and have specific prices that can dip, allowing for buyers to try and take advantage of price declines.

How long should you wait after a dip to buy?

Since trying to buy the dip is the same as trying to time the market, there is no designated or “right” amount of time to wait after a dip to buy. There’s also no guarantee that a price decline is a dip, and that an asset’s value will recover.

Does buying the dip actually work?

Buying the dip can work as a method for generating returns, but it has its risks. There’s also no guarantee that an asset’s value will recover to previous levels after it declines, or dips.

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S&P 500 Index: The S&P 500 Index is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an investment product, but a measure of U.S. equity performance. Historical performance of the S&P 500 Index does not guarantee similar results in the future. The historical return of the S&P 500 Index shown does not include the reinvestment of dividends or account for investment fees, expenses, or taxes, which would reduce actual returns.
Dollar Cost Averaging (DCA): Dollar cost averaging is an investment strategy that involves regularly investing a fixed amount of money, regardless of market conditions. This approach can help reduce the impact of market volatility and lower the average cost per share over time. However, it does not guarantee a profit or protect against losses in declining markets. Investors should consider their financial goals, risk tolerance, and market conditions when deciding whether to use dollar cost averaging. Past performance is not indicative of future results. You should consult with a financial advisor to determine if this strategy is appropriate for your individual circumstances.

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