A down stock market could create an opportunity for investors to buy the dip. In simple terms, this strategy involves making an investment when stock prices are low.
This is a way to capitalize on bargain pricing and potentially benefit from price increases down the line. 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 It Mean to Buy the Dip?
To buy the dip is to invest when the stock market is down with the potential to go back up. A dip occurs when stock prices drop below where they’ve normally been trading, but there’s an indication 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?
Dips can happen for a variety of reasons. For example, general stock market volatility can cause stock prices to tumble temporarily on a broad scale. A recent example of a dip would be the lows the market experienced in the spring of 2020 connected to economic fears surrounding the coronavirus pandemic, followed by a gradual rise in stock pricing.
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, for instance, those could trigger a short-term drop in its share price.
What’s the Benefit of Buying the Dip?
If you’re wondering, “why buy the dip?” or “should I buy the dip?” it helps to understand the upsides of this strategy.
Buying the dip is a way to cash in on the “buy low, sell high” mantra that’s so often repeated in investment circles. When you buy into a stock below it’s normal price, there is a potential (but not a guarantee) to reap significant profits by selling it later if prices rebound.
Example of Buying the Dip
Say, for example, 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 perfectly predict which way stocks will move on any given day. Understanding trend 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.
How 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.
Understand Market Volatility
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.
Recommended: How to Handle Stock Market Volatility
In the midst 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.
Consider the Reason for the Dip
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.
Buy the Dip vs. Dollar-Cost Averaging
Buying the dip is more of a hands-on 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, one can generate returns in a way that smooths out the ups and downs of the market.
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.
Recommended: What to Know About Dollar Cost Averaging
You’ll buy shares during the dips and during the high points as well but you don’t 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 a beginner learning the basics.
Knowing when to buy the dip can be tricky, but there are times when it may pay off for some investors. A few things that can help: knowing when to buy in and understanding how likely it is that a stock or the market as a whole will rebound.
You can buy the dip with individual stocks or use exchange-traded funds instead to manage risk. Both strategies are options with SoFi Invest® online trading, where investors can start trading with as little as $1.
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