As you become familiar with investing and how the stock market works, you may want to try different investing strategies. One that has become popular with some investors is "buying the dip," which refers to buying stocks when they have fallen in price. Essentially, this strategy relies on buying stocks that have dropped in value and then selling them when their prices rise—the difference allows investors to profit from the increase.
In this article, you will learn all about "buying the dip," including how it works and the risks associated with this strategy.
What Is ‘Buying the Dip’?
The term "buying the dip" is a way to invest in a stock or index that's dropped in value. The idea is that as the price dips, you might be able to pick up shares at a discount and take advantage of potential future growth if and when the stock rebounds to its previous high (or more).
Generally, the greater the drop in price, the more you stand to gain if the stock goes back up. However, if a stock has fallen far beyond its normal range, it may have changed fundamentally for reasons that will keep it from returning to its high.
How Does the Buying the Dip Strategy Work?
Buying the dip is a technique that involves holding a portion of your assets in cash or lower-risk assets and waiting for their prices to drop. If the price of an asset you're interested in has fallen, you might take your cash and buy more. That lowers your overall average cost and can enhance your returns if you hold the asset long enough and higher valuations prevail over time.
Essentially, you try to predict how the market will move in the future and then make buying and selling decisions based on your predictions. This contrasts with buy-and-hold, where you buy investments and hold them for the long term, relying on long-term gains to grow your portfolio.
Let's now apply this strategy to real-world situations and see how it works. If we rewind back to the COVID-19 pandemic, which began in February and March 2020, economic shutdowns led to a significant decrease in stock prices. The S&P 500 Index, which tracks the performance of the 500 largest U.S. companies, saw a ~31% decline in price before it hit bottom and then rallied.
Although a rebound is possible after a significant price decrease, it is also just as likely for the asset price to continue declining. The example above shows the stock market reacting negatively to the uncertainty of the pandemic. But a combination of fiscal and monetary stimulus, along with increased data and research on the virus itself, lightened fears in the stock market.
If the economy worsened more quickly or if a deadly virus killed more people than expected, the stock market might not have rebounded as quickly. There are many cases where a particular security doesn't recover and continues to drop, leading to increased losses.
Managing Risk When You Buy the Dip
Any investor who buys a stock during a period of declining prices needs to perform due diligence and analyze the company's financial records before deciding whether or not to make a purchase to avoid any future drop. If you’re going to buy the dip, it’s important to define your risk parameters before executing a buy-the-dip strategy:
- Understand the opportunity cost of holding excess cash, including lost dividends and potential capital appreciation; set a limit to the cash that remains uninvested.
- Be disciplined about the price decline. If you have a 20% threshold for selling, don’t be tempted to hold on in the hope that the price will drop further.
- Utilize different available order types i.e. stop loss to minimize your risk. This is a predetermined price at which a position should be closed. Say the price of a stock falls from $16 to $12 and the investor sets a stop loss at $14, then the investor will close the position at $14 to prevent further losses should the price continue to fall.
- Be careful of buying stocks that are in a long-term downtrend. When a stock price continues to fall, reaching a lower low with each consecutive decline, the stock is in a downtrend. This is unlikely to be a good time to buy the dip. Buying the dip can be a reasonable strategy when stocks are in an uptrend, pulling back but then moving up to higher highs.
Should You Buy the Dip?
Buying the dip does not necessarily mean that you are getting the absolute lowest price possible. In unstable markets, the price that is considered low today may be much higher tomorrow. However, this strategy can still be beneficial for investors who believe that stock prices will eventually rise again, as it allows them to buy at a relatively lower price. It’s important to keep in mind that this strategy may involve experiencing significant declines in the short term before potentially realizing long-term returns.
The 4 Best Stocks to Buy on a Dip
Below is a list of stocks InvestorPlace thinks could be worth buying during a dip.
Albemarle Corp (ALB)
As analysts have been saying for years, electric vehicles are the future. That’s why investors have sought out firms that might dominate the EV sector for years to come. However, as the EV market gets saturated it can be hard to determine which company dominates the market which is why infrastructure-related companies like Albermarle tend to be a better option. Albemarle is a little different from other companies, it doesn't just focus on the brand winners and losers in the EV industry. It provides all EV manufacturers with what they need: lithium.
Intuit (INTU)
Intuit, best known for its tax and accounting software, will likely see increased demand if the gig economy grows as expected. Tax preparation for independent contractors is more complicated than a standard W2 filing for employees. The gig economy is expected to grow thanks to the ongoing debate about whether or not workers should telecommute. Workers want the freedom to do so, but upper management prefers that they return to the office on a regular basis. If a recession occurs, corporations will enjoy even greater leverage. This may lead some part-time gig workers to become full-time independent contractors, which would be extremely beneficial for Intuit.
Archer Daniels Midland (ADM)
Archer Daniels Midland offers solutions across the food sector value chain, from farm to fork. The multinational food processing and commodities trading corporation is one of the best stocks to buy on a dip because no matter what we invent in the coming years, humans must eat, which is why ADM can be a good investment during times of trouble3.
Dividend.com reports that Archer Daniels Midland has paid dividends for 49 consecutive years. This record of reliability provides important reassurance to investors in today's environment, where many companies are struggling with high borrowing costs.
Netflix (NFLX)
In the past year, Netflix has seen a major decline in stock value, dropping approximately 51% since January4. Investors were alarmed by subscriber losses, in addition to people opting for vacationing over at-home entertainment due to the lifting of lockdowns and mobility restrictions. In spite of the fact that people's desire to take vacations was soon hindered by rising costs and job losses, consumers are still looking for ways to take their minds off their daily troubles. As Netflix provides an affordable way to do so, it stands as one of the best investments when it comes to buying stocks on a dip.
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Your investment can fluctuate, so you may get back less than you invested. Consider each product’s risk(s) before investing. Baraka is not a financial adviser and therefore does not provide financial advice. Our content is informational only.
Source:
Corporatefinanceinstitute.com
Dividend.com
Investorplace.com
