What does ' buying the dip' mean?

The catchphrase ‘buying the dip’ is an investment strategy used by some market participants to buy a stock when its price drops sharply (i.e at a discount) with the aim of getting a slightly higher upside as markets bounce back.

The core belief in this strategy is that the dip is caused by noise or an overreaction to news and not any true change in the fundamentals. Thus, by timing the market, an investor makes money as and when the asset begins to rebound.

What are the benefits of 'buying the dip'?

1. Buying the dip is a good strategy if you’re investing in a high-quality asset with a long-term upside potential. It's an opportunity to get a valuable asset at a cheaper price, like taking advantage of a sale or special promotion to purchase something you've had your eye on. 
2. Dip buying can lower one's average cost of owning a stock.
3. ‘Buying the dip’ strategy presents opportunities to make gains money provided one does the following:

• Correctly times the market
• Identifies the reason for the dip
• Identifies whether the stock is down because of a broader down move in the overall market, or is unique to the company
• Focuses only on stocks that have strong underlying fundamentals 

Illustration of buying the dip

For illustration purposes, we take a close look as to how the Nifty50 moved just before and during the initial phase of pandemic, i.e. from January 2020 until October 2020. During this timeframe, when India reported its first case (January) to the lockdown phase (March) and gradual unlocking phases (June-July), the Nifty swung from 12,000 to 7,600 and rebounded to 12,000, providing numerous dips as buying opportunities to investors.

What are the key challenges of the 'buying the dip' strategy?

While 'buying the dip' is a commonly used investment strategy by investors, it has its own risks, especially when used by first time traders and investors.

• The dip may take longer than anticipated to rebound 

The risk is that of buying a stock whose price won’t recover within a short period as anticipated and may even pose a challenge to the investor cash flows.

For example, it may take two or three quarters for a fundamentally strong company’s shares to recover after it reports a bad quarter, slashes its dividend, reports the demise of a CEO, or even loses a patent. 

Situations like these are temporary. However, they may take longer than anticipated to normalise. Like the famous economist John Maynard Keynes said, “the markets can remain irrational longer than you can remain solvent."

• The dip may get deeper, showing no signs of a rebound

In most cases, the market tends to overreact, making the buy-on-dip strategy ideal. However, one needs to carefully understand how deep the dip will continue. What if the dip turns out to be a cliff?

For example, one can examine the trading pattern of the stock through its 52-week high and lows and analyse the time frame of rebounds and reasons for sharp corrections. In addition to stock price trends, it is also useful to examine the institutional ownership level and company valuation. 

However, in some cases, the price continues to fall, showing little or no sign of a potential rebound. 

• There is a risk of being too optimistic about timing the market

'Buying the dip' may appear as a sound investment strategy of buying into stocks at low prices and selling them on their way to rebound. However, the major drawback is the risk of being too optimistic as seeing a dip as only a dip. It could be a cliff or a trough. Some assets dip and just keep falling. Buying a never-ending dip after dip will wreck your portfolio.

Secondly, this strategy entails timing the market perfectly which is easier said than done as investing in stock markets is far more complex than ever. 

Summary

Scooping up stocks after pullbacks is at best a tactical approach, there are no shortcuts to disciplined and consistent investing.

Investing today is more complex than ever. With stocks rising and falling on very little news while doing the opposite of what seems logical. Also, one of the hardest questions about  investing is how to tell the difference between a dip (which wise investors ride out) and a company that has truly lost its value (in which case it’s probably time to sell).

Famed investor Peter Lynch stated that “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”