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Sept. 25, 2021, 2:21 p.m. EDT

‘Buy the dip’ is a horrible stock-market strategy — and these charts prove it

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By Nick Maggiulli

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And while it sits in cash, the market tends to go higher. As a result, you end up buying at much higher prices than if you just bought from the outset.

For example, imagine deciding not to buy until there is a 20% dip in the market. Now imagine that the market doubles without any such dip. Even if the market were to immediately dip 20%, prices would still be 60% above where they were when you started investing. Therefore, when you buy the dip, you end up buying not at a 20% discount, but at a 60% premium.

This is why Buy the Dip is such a terrible investment strategy. When it wins, it tends to win by a little, but when it loses, it can lose by a lot.

This asymmetric performance profile is what makes it such a subpar investment strategy. And if we look across a variety of dip buying thresholds, we can see why.

Does dip size matter?

Given what I have discussed thus far, you might be wondering whether the size of the dip you wait for matters for this strategy. For example, is waiting for a 50% dip better or worse than waiting for a 10% dip? Well, it depends on what you mean by better.

Technically, you are less likely to outperform DCA in the long run by waiting for smaller dips than by waiting for larger dips. As the table below shows, the larger your dip threshold, the more likely you are to outperform DCA over some random 20-year period between 1920 and 2020:

This chart shows that there is roughly a one-in-four chance of beating DCA when using a Buy the Dip strategy with a 10% to 20% dip threshold. If you were to use a 50% dip threshold, the chance of outperforming DCA increases to nearly 40%. But this doesn’t come without a cost. Because while you are more likely to outperform DCA when using a bigger dip threshold, you also underperform by more (on average) as well.

As the table below illustrates, the median amount of outperformance when using Buy the Dip for 20 years ranges from -5% to -13% depending on which dip threshold you use (Note: negative outperformance is the same as underperformance):

What this means is that if you looked at all 20-year periods from 1920 to 2020 and followed Buy the Dip with a 10% dip threshold, you would likely underperform DCA by about 5% in total (i.e. the median outcome). If you used a 50% dip threshold, you would likely underperform DCA by about 13% in total.

If you look at the distribution of relative performance by dip threshold, we can get better view of what is going on. The chart below shows how much Buy the Dip outperforms DCA (in total) for each dip threshold specified across all 20 year periods in the data.

So imagine we compare Buy the Dip to DCA from 1920 to1940 using a 10% dip threshold. Then we do this for 1921 to 1941, 1922 to 1942, and so forth through 2000 to 2020. After that, we do all of those simulations again for a 20% dip threshold, 30% dip threshold, and so forth up to a 50% dip threshold.

Finally, we plot the distribution of the performance of Buy the Dip compared to DCA over all these simulations:

As you will see, while a smaller dip threshold is less likely to outperform compared to a larger dip threshold, the size of its underperformance will usually be smaller as well.

What this chart illustrates is that what dip threshold you use determines the likelihood and the size of your outperformance (or underperformance) relative to DCA. As the dip threshold gets bigger, the outperformance curve flattens with the middle of the distribution moving leftward (i.e. more negative on average). This means that, when your dip threshold increases, the outperformance is more extreme, but the underperformance is also more extreme as well.

From this plot you can see why it can be worth it to wait for larger dips, but only if you get lucky. Because if you don’t get lucky, be prepared to lose a lot relative to DCA.

The bottom line

While it can be intriguing to stockpile cash to buy the dip, the data above suggests that this strategy is unlikely to win out in the long run. If you happened to successfully buy the dip once, take your victory lap then get back to investing  as soon as you can . Though you might think you have the ability to market time, I suggest attributing your trade to good luck and then moving on.

The reason why Buy the Dip usually fails is simply because market dips, especially larger dips, are rare. Without dips to buy, Buy the Dip is just an 100% cash strategy, which is a terrible way to invest for the long term. More importantly, while large dips can generate larger returns, predicting them beforehand is near impossible. So be careful before waiting for one because your portfolio is likely to miss out.

Lastly, while the analysis shown here was done on U.S. stocks, you can generalize it to any asset class that is expected to have a positive long-term return.

If you want to argue that Buy the Dip beats DCA for some asset class that dips a lot more than U.S. stocks, then have at it. Because I don’t know about you, but I like to buy assets that tend to go up.

Nick Maggiulli is the author of the blog “Of Dollars and Data,” where this was first published as “Why Buying the Dip is a Terrible Investment Strategy.” Follow him on Twitter @DollarsAndData.

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