By Nick Maggiulli
I’ve previously written about why buying the dip can’t beat dollar-cost averaging, even if you were God . However, I feel like that article was a bit too extreme. Buy the Dip was defeated in one fell swoop. It never had a fighting chance. There was no last meal, no departing words, and no funeral procession that followed.
But today, I’m going to change all that. Because today I’m going to give Buy the Dip the proper burial that it deserves and demonstrate without a reasonable doubt why it is a terrible investment strategy.
To start, let’s imagine that you are dropped somewhere in history between 1920 and 2000 and you have to invest in the U.S. stock market /zigman2/quotes/210599714/realtime SPX -0.84% for the next 20 years. You have two investment strategies to choose from:
Dollar-cost averaging (DCA) : You invest $100 every month for all 20 years.
Buy the Dip : You save $100 each month in cash until the market dips below a certain amount from its all time high (i.e., 10%, 20%, etc.) Once the market dips enough, you invest all of your saved-up cash and continue investing $100 each month until the market hits another all-time high. At that point you go back to stockpiling cash until the next dip of the same size occurs. Rinse and repeat throughout the entire 20-year period.
The only other rule in this game is that you cannot move in and out of stocks. Once you make a purchase, you hold those stocks until the end of the time period. So what would you choose? DCA or Buy the Dip?
Before you answer that question, let’s review how Buy the Dip works so you can see it in action.
How Buy the Dip works
To visualize how the Buy the Dip strategy works, consider following it from 1970 to 1990 with a drawdown threshold of 40%. What this means is that you will save up cash and only buy once the market is 40% below an all-time high. After this 40% dip occurs, you then keep buying each month until a new all-time high is reached. At the new all-time high, you repeat the process and start saving cash once again, waiting for the next 40% dip to occur.
You can see this in the chart below which shows the Buy the Dip cash balance over time (green line) and when it makes purchases (red dots):
What this shows is that from 1970 to 1974 you are saving cash until the market is 40% below its all time highs. It’s at this point when you finally invest that cash following the 1974 crash. You then keep investing $100 every month (just like DCA) until 1984. It’s at this point when the market eclipses its all-time high from December 1972 and you go back to saving up cash again.
If we were to visualize how Buy the Dip compares to DCA (i.e. buying every month) over this time period, we would see that Buy the Dip portfolio would win out over time:
As you can see, Buy the Dip starts outperforming DCA as the market starts to decline in the early 1970s. Buy the Dip then gets invested after the 1974 crash and retains that lead for the rest of the time period.
Why Buy the Dip wins by a little and loses by a lot
As good as the 1970-1990 time period was for Buy the Dip, its best performance relative to DCA occurred from 1963 to 1983. It was during this period when Buy the Dip outperformed DCA by 29% in total, as shown in the chart below:
Similar to our previous chart, Buy the Dip starts saving cash in 1963 and only gets invested in the market during the decline of 1974. It’s at this point when Buy the Dip takes a lead over DCA that it never gives up. While this might seem like I am arguing for the Buy the Dip strategy, I’m not. This just happens to be one period where that strategy would have performed quite well.
Unfortunately, there are many more periods where Buy the Dip doesn’t perform quite so well. For example, if you had followed Buy the Dip from 1980 to 2000 with a 50% drawdown threshold, you would have sat in cash for the entire 20 years while the market ripped upward:
Why does Buy the Dip sit in cash for the entire 20 years? Because there are no 50% dips to buy during this time period. As a result, Buy the Dip never gets invested. And because it never gets invested, DCA ends up outperforming it by 5x ($120,000 vs. $24,000) over 20 years. That’s a massive amount of underperformance.
While this is an extreme example, it highlights the primary issue with Buy the Dip—it sits in cash for far too long.