Table of Contents:
- How buying the dip works
- Limitations & risks of buying the dip
- Examples of buying the dip
- FAQs about buying the dip
- The bottom line
As you become familiar with investing and how stocks work, youll want to expand your knowledge and try different trading strategies. One that has become popular with some investors is called buying the dip.
If youre familiar with some of the investing groups on Reddit or other platforms, you may have heard the term but might not be clear on what it is or how its used. Basically, this strategy is built on the belief that a price drop signifies a stocks bargain price and the expectation that it will likely jump back up. The increase in value allows investors to profit from the difference.
One core principle of investing is to buy low and sell high. Buying the dip ticks the first box. For investors looking for potential opportunities to trade during a downturn, two signals to evaluate when spotting stock dips are (1) a sharp drop in the stocks price and (2) the probability of it bouncing back. Obviously, the probability of it bouncing back is very difficult to predict.
Key Takeaways:
- Buying the dip is a strategy where investors buy stocks that have had a sharp drop in the price with a strong probability of it rising again to ensure they profit from the trade.
- Buying the dip is about timing the market, which is difficult to do under any circumstances.
- Although downtrends in the market can provide opportunities to buy the dip, the strategy isnt as simple as it sounds and may not be a beneficial plan for beginner investors.
How buying the dip works
When youre learning how stocks work, you may come across several strategies for those who want to buy the dip without attempting to time the market. You just need to know where to find those opportunities.
- Research large industries – Many types of industries experience dips for common reasons, so evaluating price declines by sector can offer the chance to find promising opportunities to buy the dip.
- Max out contributions to your 401(k) – When prices decline, it may be beneficial to contribute more to your 401(k), as long as you dont jeopardize your emergency funds. This means youll be buying more of the investments you own at discount prices and increasing the value of your portfolio when prices rise again. Just be aware of contribution limits.
- Implement dollar-cost averaging – One of the leading ways to save for the future over the long term is investing, and experts agree that making regular contributions ensures the best chance for success. The benefit of this strategy is that if you are making regular contributions, youll buy the dip automatically as you continue to invest when prices hit a downtrend and benefit when prices bounce back with no need to try to time the market.
Limitations & risks of buying the dip
Theres no shortage of investment strategies, but none of them can guarantee better or faster returns. Moreover, the stock market is constantly changing, and short-term strategies may not always work in our favor, including buying the dip. Theres no substitute for understanding whats happening in the real world and how thats going to affect stock prices.
Some limitations include:
- Stock prices can drop for a wide variety of reasons, so before jumping in, you want justifiable confidence that its going to rebound. Do your research, but exercise caution. Remember: dont invest money you cant afford to lose.
- When learning how to invest in stocks, it can be challenging to identify the difference between a dip and a signal that a price drop is leading to a more significant downturn in the market, which could lead to a low chance the stock will recover anytime soon.
- Buying the dip to add more stock to your portfolio isnt always a beneficial move without additional reasons.
- Some reasons that a stocks price may dip include a drop in company earnings, slow growth, management disruptions, interest rates, inflation, and market tribulations.
Managing investment risks when buying the dip is vital for investors. Some tactics include:
- Set limits for losses after buying the dip. For example, if you buy the dip stocks at $12, and the share price drops to $10, you may set a limit to sell if the price dips to $9 to cut your losses in case the price keeps dropping.
- Buying dips during uptrends may be more beneficial, as pullbacks are a normal part of an uptrend.
Example of buying the dip
Although buying the dip may have some benefits, there can also be some significant downsides. In 2007 and 2008, there was a financial crisis, and Wall Street, along with a variety of financial companies, was hit hard. New York City-based global investment bank Bear Stearns, which was founded in 1923, was one of these companies.
Bear Stearns had survived the U.S. stock market crash of 1929 and, due to economic growth, became the 5th largest investment bank in the world with over $18 billion in assets. But in 2007, the bottom fell out of the real estate housing market. As a result, their mortgage-backed securities were overexposed, and Bear Stearns ultimately collapsed.
Any investors who had expected a promising opportunity to buy the dip, and anticipated prices to rise again to new highs, were shocked and disappointed after a company that seemed to survive a variety of devastating financial downturns could not recover.
Of course, in contrast to Bear Stearns, we have Apple with shares that started at $3 and have jumped to more than $160 per share. So, buying the dip may have offered a more successful transaction in this case.
FAQs about buying the dip
Q:Does Warren Buffet buy the dip?
A: According to Yahoo Finance, Warren Buffets investment strategy is to invest in stable companies that offer dividends and long-term value rather than short blips of highs and lows.
Q:Is buying the dip a good idea?
A: Buying the dip isnt as easy as its perceived to be and can involve a lot of waiting for market dips and rises, ultimately putting market timing at the core of the strategy. Even when a price dips, theres no guarantee that it will rise again, making it risky at best. Deciding whether its a good idea is up to each individual investor.
Q: When should you buy on the dip?
A: Theres a lot of uncertainty when it comes to buying the dip, but investors who use the strategy may buy when prices drop to lower prices in hopes they will bounce back. But truthfully, buying too early in a downturn could mean prices will continue to fall and may never rise high enough to see gains, so the risks are very real.
Q:What stock would be promising when buying the dip?
A: According to Nasdaq, a few suggestions for companies to test out buying the dip include Apple, Tesla, Microsoft, Amazon, Visa, and Mastercard, to name a few. Although these companies may seem to have less volatility, investing is fundamentally full of risks. Buying the dip is a strategy in technical analysis that includes attempting to time the market, which is no easy task.
The bottom line
Investors are always looking for better, faster ways to make a profit. Still, with all the stock market uncertainties, its a good idea to evaluate opportunities thoroughly to ensure they are suitable for you and your investment goals.
Are you ready to learn more about trading strategies? Then, be sure to view our article on Technical Analysis and download the Public app to get started investing today!