The perfect dip is an illusion and for waiting for an index to be low enough before buying is a flawed strategy, according to John Plassard, senior investment specialist at Mirabaud Group, who is “fascinated” and “baffled” at the same time at the stock market adage of ‘buying the dip’.
This investment strategy consists of buying a financial asset when it falls sharply to bet on a theoretical rebound. The concept is rooted in history – after the 2008-2009 financial crisis, for example, investors who hesitated missed a strong market rebound. It also makes sense: buying at low prices increases long-term gains and avoids paying the highest prices.
But although buying after a downturn may seem like a good strategy, corrections do not follow a predictable timetable and markets can go for long periods without a significant downturn. Is it also impossible to predict how much an index will fall in any given year.
Plassard quoted some data compiled by Ben Carlson, director of Institutional Asset Management at Ritholtz Wealth Management, on the performance of the S&P 500 since 1950.
The index fell by 10% or more 36.6% of the time and by 20% or more 16.6% of the time. Declines of 30% or more occurred only 5.4% of the time and of 40% or more were even rarer (2.3%). All-time highs were only reached 7.7% of the time.
This means three things to Plassard. One, volatility is normal: investors should expect frequent corrections and falls; two, market downturns are often temporary and therefore long-term investors are well advised to stay invested as history shows recoveries follow downturns; and three, severe crashes of more than 50% are exceptionally rare but corrections of 10%-20% are common, reinforcing the need for risk management and diversification.
“History shows that staying too long in cash while waiting for a correction can be costly, especially when the market continues to rise over several years. Historically, the major indices have always recovered their losses, but not all equities necessarily return to their peaks,” Plassard said.
“Past examples, particularly after 2008 and 2018, illustrate that those who were able to invest during downturns without waiting for a theoretical low point benefited greatly from recoveries. However, a blind approach to the dip can lead to costly mistakes.”
So buying the dip is right in theory but hard in practice. Yet it also poses the additional challenge of knowing when to sell, as market corrections are inescapable but do not occur with the same regularity.
The S&P 500 has experienced a double-digit correction six times in the past 10 years, and in two of those cases (2020 and 2022), these were genuine bear markets with the market down more than 20%.
But these corrections were often very slow to arrive. Since 1950, there have been more than 20 periods when a correction of 10% took more than a year to arrive, and in five cases this period exceeded three years – the record is the seven-year period between 1990 and 1997 without the slightest correction.
In such a context, Plassard explained, remaining liquid while waiting for a downturn can be extremely costly, especially when the market doubles in value before starting to fall again.
“If a strategy consists in allocating 20% of one’s portfolio to bonds and buying equities as soon as a 10% correction occurs, investors still need to clearly define when to sell these equities and switch back to bonds,” he said.
“And therein lies the difficulty: while buying on a pullback may seem obvious, exiting is much less so, especially as some bull markets can last for years without any significant correction.”
In conclusion, buying the dip is a risky approach, as ultimately, investors are trying to time the market and predict by how much and for how long an asset will fall – an impossible feat. The challenge is also knowing when to act and how long to be prepared to sit on the sidelines waiting for the next opportunity, which can prove costly.
Plassard’s therefore concluded that “maintaining a diversified and disciplined approach seems to be a better answer than the quest for perfect timing”.