Buying the dip: what is it and does it work?

Buying the dip is a strategy used by some investors and traders to buy shares in a company when the price has taken a dip, or a fall, in the hope it will rise again beyond the purchase price. But it’s a risky strategy as things might not go the way you’d hoped.

Share prices can rise and fall all the time due to a number of reasons. The trend over time for companies listed on the Australian Securities Exchange (ASX) has been for the share market overall to rise.

For example, the All Ordinaries index (ASX: XAO or All Ords) tracks the movement of the top 500 companies listed on the ASX. It started life in 1980 with a value of 500 and as of the end of December 2021 it was listed at 7,779.2.

But over that time the index has had many peaks and troughs, some that coincided with a number of events happening locally and globally.

Read more: Australian Shares Performance in the Last 30 Years

Within that overall trend some companies may have seen their share price rise and fall many times, like a roller coaster ride. But unlike a roller coaster, some companies never return to base and may see their share price grow over time, while others may never recover from a previous high.

When should you buy the dip?

The challenge for anyone looking at buying the dip is knowing when a particular company (or companies) share price will fall, and then whether it will later recover.

That also depends on whether you are looking for any short-term or long-term gain.

Tim Wedd, an Executive Director at Crystal Wealth Partners, told Canstar that if you wanted to consider buying the dip as an option then you should consider it as a part of a long-term investment strategy.

“Everyone gets excited about buying the dip,” he said.

“Sometimes they will get it right and sometimes they will get it wrong.

“Not every dip is the same.”

There are many reasons why a company’s share price may fall. It could have delivered news on performance and profits that were not as good as investors expected. Or there could be some other reason why investors choose to sell, leading to a price fall.

A share price drop could also be part of a wider dip in the markets, such as what happened in the global financial crisis (GFC) that started in 2007, or in the early days of the COVID-19 pandemic in 2020.

People may have different expectations on what they consider a dip. A drop of 1% in share price may be enough to attract some investors while others may be looking for a more significant drop of 5%, 10% or more.

The challenge for any investor looking to buy the dip is knowing when to buy into a falling share price.

“It might have more to go down,” said Mr Wedd.

That’s why he suggests people look more towards the long-term for any potential future rise in a share price, above the purchase price.

While past performance is not a reliable indicator of future performance, research by the investment company Vanguard suggests investing in the sharemarket over long periods has been a profitable approach for investors, and more so than other asset classes.

Its 2021 index chart shows Australian shares achieved a return of 9.7% a year over a 30-year period compared to 8.6% in property, 4.6% for cash and a consumer price index of 2.4% over the same period.

Vanguard’s Head of Personal Investor, Balaji Gopal, said “history shows, despite the peaks and troughs, average market returns will trend upwards over time”.

That potential for a trend upwards is not guaranteed though and doesn’t take into account the performance of individual shares in the market that may never recover from a fall. Any potential recovery may also take time. It was 2019 before the All Ords reached its pre-GFC closing high from November 2007, only for the market to take another big fall when the COVID-19 pandemic hit.

All Ordinaries Price Index 2007-2022

Why should you buy the dip?

Some people may look to buying the dip to increase their share holding in a particular company they’re already invested in. Others may be looking to make their first purchase in a particular company.

But buying shares in a company just because its share price is falling is not a good strategy if you don’t know anything about that company. There could be a good reason why its share price is falling.

Mr Wedd told Canstar you should already have your eye on a particular company or market sector you want to invest in. It should be something that’s part of your investment strategy and you’ve probably already done your research homework on that market ahead of any potential dip in the share price.

If the share price in a particular company does fall, cautious investors may consider making only a fraction of the investment they had in mind, say just 50%, saving the rest for any later investment, depending on the share price movement. Others may choose to make a larger investment early on.

Either way, Mr Wedd said you need to be clear on what you are trying to achieve.

“If you are looking at this because you want to be in it for the long term, you don’t have to worry too much about the short term,” he said.

“Markets are very forward looking, always trying to anticipate what the next move will be.”

The risk of buying the dip

Knowing when to buy and when to sell any shareholding is always a risky business.

But the risk of buying the dip is that the share price of a particular company may not recover as you expected, or recover at all.

As with any investment strategy, you may be wise to seek professional financial advice before making a decision.

Cover image source: bdomanska/Shutterstock.com