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You may have heard the phrase in investing: “buy low and sell high”. Yet what does this mean, exactly, and is it an effective way to grow long-term wealth? In this article, our team at Cedar House examines the evidence in light of our experience as financial planners. We hope you find this content useful. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or email@example.com
What is buying the dip?
Buying the dip involves committing a lump sum to the stock markets when they fall considerably. A recent example can be seen with COVID-19. In March 2020, the UK and US stock markets both fell dramatically after the pandemic hit the stock (equity) markets. Panic spread amongst investors, leading to more and more people selling their shares. Between 12th February 2020 and 23rd March 2020, the Dow Jones lost 37% of its value. The FTSE 100 in the UK also fell from 7,403 in late February to 5,190 a month later.
Yet by April something remarkable started to happen. Amidst the lockdowns, covid spreading, business disruption and travel suspension, stock markets started recovering. By early June the FTSE 100 was up to 6,484, and the Dow Jones was almost back to its February high by August. Those who sold their stock market holdings in March likely lost a lot of money; perhaps 30% or more. Yet those who “bought the dip” in March – by committing a large sum – and held it into the following year likely made a lot of money as the markets rebounded.
An alternative to buying the dip
Instead of waiting for a stock market crash and committing a large sum of cash you’ve been saving, you could “pound cost average” instead. This involves contributing smaller, regular sums into a pension or investment portfolio; bit by bit. The advantage of this approach is that it offers some protection against the chance of stock markets falling sharply after you invest a lump sum. This can help more “cautious” investors protect themselves from regret.
Pound cost averaging is also, often, the only option for people who do not have a large sum to invest, but rather can set aside a small amount to invest each month from their paycheque. Yet there are disadvantages to “drip feeding” a large amount of cash, gradually, into stocks. First of all, there is the “opportunity cost” of holding cash. Suppose you inherit £50,000 and decide to gradually put it into stocks over, say, two years (i.e. about £2,083 per month). The interest you generate on the cash – comprising most of the portfolio until year two – will be meagre; less than 1%, most likely. By not investing more cash earlier, you risk missing out on more investment growth that you could have generated. Secondly, there is the possibility that you will rack up more fees with pound cost averaging. If your broker charges you for each transaction, then the more transactions you engage in (e.g. monthly versus just one) the more you will be charged.
Does buying the dip work?
Part of the problem with “buying the dip” is that, first of all, you may be waiting a while for it to arrive. Over the last 50 years, the S&P 500 in the USA has experienced some form of market decline 29 times. Going back to 1928, a correction of at least 10% has happened, on average, once every 19 months. In the meantime, you could be missing out on investment growth by holding lots of cash – rather than putting into other assets. Secondly, when a dip (i.e. a stock market correction) does arrive, how do you know when you have “hit the bottom”? Suppose the market falls by 25% within a month. Should you invest your lump sum now? How do you know that this is the start of a turnaround, rather than a moment when a further fall might happen?
The main problem with the “buy the dip strategy”, however, is that it doesn’t outperform pound cost averaging in every time period. For instance, suppose your strategy is that you will save up cash until the market falls 50% below an all-time high. At this point, you invest a bit more each month until a new all-time high is reached. At which point, you start saving cash again until the next 50% drop from a historic peak. Had you started following this strategy in 1980, you likely would have sat on cash for 20 years until 2000. In that period, however, the markets roared up, which means this strategy would have resulted in a huge opportunity cost loss.
So, what should you do if you have a pot of cash, ready to invest? The answer partly depends on the stock market, your goals, your investment horizon and your risk tolerance. For the best route to clarity and peace of mind, consider speaking with a financial adviser.
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or firstname.lastname@example.org