Today I want to discuss one of my favorite investing mantras. You’ve probably heard this one before. It’s called “Always buy the dip.” It’s a phrase that’s fairly common in the investing community. So, let’s discuss what it really means, the principle behind it, and why a lot of people try to implement ‘buying the dip’ into their strategy.
The image above is the Dow Jones industrial average over the course of the last year. One of the basic tenants of investing is the belief that if you trust in the US economy and look at a long enough time period, the stock market will continue to go up. So, if that’s the case, then you should try to buy low and hold until the markets recover and stock prices increase. Right?
Well, that’s the funny thing. When the markets move lower, people don’t actually do this. Instead, they listen to their emotions and the fear of losing money takes over.
It’s a fundamental problem with the way many investors think. Rather than look at history and realize the markets always recover, they believe any slight downtrend in the markets is going to turn into the next recession and start selling. And, inevitably, this fear based selling is a viscous cycle and the markets trend lower.
Sure, they save a little money by selling. But, in the long run it would have been more profitable to stay in the markets and actually buy more shares of blue chip companies while prices are cheap.
This is another reason why diversification is important. Going back to the all-time graph of the Dow Jones, we can see that the market recovered after the Great Recession. If you held through it, you would have eventually gotten back to point where the overall market had recovered. However, not every single company made it through the Great Recession. In fact, many notable stocks went bankrupt or got acquired at extremely low prices. People whose portfolios were weighted heavily by those stocks ended up losing a lot of money.
However, if you were well diversified, you may have lost money on those individual stocks but the gains from other stocks in your portfolio would have compensated and you would have come out alright.
At the end of the day, this panic when prices start falling is what you need to avoid. A pull back or dip in the market is in fact a good thing. It allows you to acquire more shares at a lower valuation.
Alright, so now that we know the market has always recovered, let’s get back to how you can start ‘buying the dip’ and integrating this into your investing strategy. Let’s start by looking at a much smaller time frame, like a year.
Over the course of a year, the markets can fluctuate wildly. So, when prices go down significantly, you should start looking to buy rather than sell or stay out of the markets.
This is why being a long term investor is so important. You should always be thinking about your returns over the next 10-15 years rather than looking for a quick profit. With this mindset, you’ll be able to get into the market during periods of attractive valuations.
The next logical question to come up is ‘how do you know when it’s the bottom? What if prices continue to fall?’
That’s truly a great question. The guy that can figure out how to consistently time the bottom of a dip or pullback would be the richest person in the world. But, it’s just not feasible. There’s just no way to know.
That’s why you shouldn’t even worry about timing the bottom. As long as the valuation is attractive and you believe that that company will grow revenue and profits in the future, it’s a good time to buy. Because at some point, institutional investors will realize the same thing you have and they’ll start purchasing shares which will increase demand and drive the price per share higher.
A Recent Example of Buying The Dip
Alright, let’s discus a specific example of ‘buying the dip’. Those of you that follow my blog may know that I recently purchased shares of Halliburton (HAL). Their stock had dropped almost 40% over the course of the last six months due to the drop in oil prices.
At face value, this might seem like a terrible reason to buy. They lost 40% in value, so there must be something wrong? Well, if you look at HAL one level deeper, you’ll realize that nothing has really changed. The price of oil has changed, which drove their revenue and earnings guidance lower. But Halliburton itself is fundamentally the same company. Nothing has inherently changed about Halliburton or what type of services they offer.
So there are two ways this can play out. First, oil continues to fall and the US economy tanks. In that scenario, I lose money on Halliburton but that would be the least of my concerns as the US infrastructure crumbles. In the second scenario, oil prices go back up and Halliburton returns to their historical revenue and gross margin levels. This increases their valuation which drives the price per share back up.
Both scenarios are possible. However, based on historical trends, this is most likely a business cycle and oil prices will return. So, we ‘buy the dip’ and invest in the energy sector while long term valuations are under priced with the intention of holding for a very long time.