Investors facing a bear market, when prices tend to fall, are faced with a choice with their investments: hold, sell or “buy the dip”.
Stock market trends
Bear markets are generally not selective about which stocks are affected by a drop in price. Both good and bad companies see share values fall. The reason? Traders follow the trend by selling, and investors run away due to pessimism and fear of losing even more money than they already have.
If your stocks are down with the rest, what you have until you sell are paper losses. And there is hope in an important principle of financial history. Stock markets eventually recover from these declines and always tend to rise over time. The time frame for a rally can be two months or two years — the date of the market “bottom” cannot be known until it has already occurred.
Eventually, however, confidence returns and investors decide they are ready to put their money at risk again. They stop selling and start buying, and as they do, prices stabilize and then start to rise.
3 ways to buy the dip
The goal of going back and buying the dip is to buy smart and cheap. There are useful strategies to follow, and once the skill has been mastered, a confident investor can profit from the anticipation of the upcoming bull market.
1. Don’t buy on Impulse
Bear markets, by common definition, occur when a stock index like the S&P 500 falls from a recent high by 20% or more. Individual stocks, of course, can fall more than that. An example of a bear market would be the first half of 2022, when high-flying growth stocks such as Cisco and Salesforce lost more than 30% of their value.
To experienced market watchers, sharp price declines look like a clearance sale. Before diving into the stock market bargain bin to try and buy the dip, however, it’s wise to assess your own financial situation.
- Is it a good time to risk money?
- Do you really want to challenge the downtrend and try to guess the market?
- Would your money be better spent paying off debt or used to bolster an emergency fund?
Instead of volatile growth stocks, how about putting newly available capital into more conservative investments like savings bonds, which are backed by the US government and only require a minimum investment of $25 ? In addition, bank savings and money market accounts have increased their yields, which are now approaching 2% at some banks.
The price that might seem like too cheap a bargain may be an honest value, given the state of the economy and the company’s future growth prospects. If “the trend is your friend”, as market veterans often say, then perhaps the smart game is waiting for the trend to reverse.
This means patiently waiting for a series of higher lows in the stock price and the market remaining stable even in the face of bad news. These are signals that investor confidence is beginning to return.
2. Do the research
Not buying on a whim involves doing thorough research on investable companies. This means reading the latest quarterly and annual earnings reports, checking balance sheets and income statements, and considering the stock’s historical price-to-earnings ratio.
Any stock will have a P/E range, with the high indicating a period of peak investor optimism and the low indicating how cheap the stock is when the company is out of favor. Following this indicator is a good way to evaluate the stock. Is the P/E falling with the rest of the market or because the company is making better profits and not being recognized for it?
If the stock price has fallen due to low earnings, high leverage, or a change in business outlook, buying low may result in an even lower sell as the stock continues to fall. Your valuation of a business should always consider the health of the business, regardless of general market conditions.
This is where a careful reading of the financial media comes in handy, as well as browsing through those wordy corporate reports, most of which are available online. Prioritize companies with:
- Positive and increasing cash
- Profit growth
- Low debt
- Good management
- Favorable business trends
Avoid the flavor of the month or the week: hip but unprofitable businesses. Also watch for those that could be negatively affected by larger economic events, such as shifting consumer sentiment or increased competition.
3. Think long term
Traders try to time the swings in the market, while investors take a long-term view. They realize that prices fluctuate daily, with low and high days constantly alternating. When this aspect of the market is understood, it is easy to ignore short-term fluctuations and stick with a good company, regardless of price.
Chances are that a good investment will end up gaining more buyers as long-term investors hold onto their stocks and the price rises to much better levels.
Generally speaking, buyers and holders fare better than day traders, who enter and exit stocks as prices rise and fall. Investments held for more than a year are subject to lower tax rates when sold, and brokerage fees can affect results when trading frequently.
However, buying and holding requires patience, as well as the ability to ride out price drops without worry. If you’re feeling a bit overwhelmed by market volatility, it might be wise to switch from individual stocks to diversified investments such as equity mutual funds or index funds, which ease the pain by investing in a large group of individual companies.
Bear markets can be daunting for the most optimistic and loyal investors. With experience, however, these same discouraged investors begin to see a bear market as an opportunity.
The key is to devise a plan that suits your own investment approach and stick to it. In time, you will recognize that a declining market is an ordinary feature of the financial landscape, and this view will greatly reduce the level of fear.
- What does the expression “buy the dip” mean?
- The phrase refers to buying stocks when their prices are trending lower with the aim of making a profit when prices start rising again.
- Is “buying the dip” a good strategy?
- This is a good strategy only if done after thoroughly researching the business to ensure that its business is still viable and profitable.
- What is the opposite of buying the dip?
- The opposite strategy is known as “Sell the Rip”, or unload stocks when their prices rise too far, too fast.
Our in-house research team and on-site financial experts work together to create accurate, unbiased and up-to-date content. We check every stat, quote and fact using trusted primary resources to ensure that the information we provide is correct. You can read more about GOBankingRates processes and standards in our Editorial Policy.