Buying the Dip? 1 Risk to Avoid and 1 Tool to Use

Shares of MercadoLibre (MELI -1.68%) are down 43% from their all-time high, as of this writing. That's a big drop for a quality company and investors might be wondering whether they should buy the dip. And this doesn't just apply to MercadoLibre -- many stocks are sharply down from their 52-week highs.

In this video from Motley Fool Backstage Pass recorded on Jan. 6, Fool contributor Jon Quast warns investors of a bias called price anchoring, something to be avoided. Fellow contributor Travis Hoium advocates for an investing method called dollar-cost averaging and talks about why this is a great tool for long-term investors.

Jon Quast: "Why isn't anyone emphasizing, now is a good time to buy stocks, dips everywhere? If you can afford it, why not increase your exposure? Upstart, DigitalOcean, Sea Limited, Bill.com, Cloudflare, MercadoLibre," are the examples that he throws in there.

Let me start off by saying, let's be very cautious of what's called price anchoring. What price anchoring is, and it works two ways. Price anchoring is when you set your mind what the right price of a stock is. Let's say that the stock is trading at $20 and you fix it in your mind, and then it jumps up to $50. You've anchored on that $20, now it feels like $50 is too much and so you don't want to buy that stock. The reverse can also happen where we anchor on a $100 per share and it drops to $40, and we say, "This is a good deal because it was a $100." In reality, both of those things, we're price anchoring to something we need to make sure that what we are deciding is based on the business fundamentals. Again what I talked about earlier, is this something that is going to create long-term shareholder value? A lot of the companies that you mentioned, I think fit that category.

But as far as dips go, I think that we all look at this a little bit differently. I did want to point out with MercadoLibre, something that I noticed this morning with it. This is MercadoLibre over the last five years, and this is the price-to-sales ratio. Many ways that you can try to value a stock, they all have their flaws, they all need to be used in context, and they all have their advantages as well.

But just looking at the price of MercadoLibre's business versus how much revenue they generate, currently trading around nine times their trailing sales. Over the last five years, they've only traded this low one other time, and that was in 2019. Now, the price over that timeframe, this is a huge winner, up over 500%, close to 600% over the last five years. They're growing those sales very rapidly. But only one other time that you could have bought it for price-to-sales ratio of nine. Of the companies that you mentioned there, Long Time Listener, First-Time Caller, I think that that is one of those that has fallen to what has historically been a very rare valuation now.

Whether or not, that makes it a great stock for you to buy today is a totally different issue. We need to certainly look at the company going forward. There are some struggles going on in Argentina right now, some regulatory issues as far as financial-technology companies that you do need to be aware of. But that is one of those companies that I really like right now.

Let's keep going, or you want to say something there, Travis?

Travis Hoium: No, I just wanted to add that this is one of the reasons that I think buying a stock over a period of time. I like to buy a little bit here and there, because I'm really bad and I think most of us, all of us are really bad at figuring out what is the right price for a stock short-term.

We think as Foolish investors about what is the company that going to be in 10 years? If I'm buying at an average price over the course of let's say a year, then theoretically I should get a dip and maybe I'll pay a little bit more, but over the course of those 10 years that I'm holding the stock, I'm going to get in at a good price and not worry too much about whether I'm buying the right dip or I'm buying a falling knife as we say. That's one thing I would caution too is a dip can always get worse, and so thinking about I'm going to keep adding to this position because I have the capital to keep add into the portfolio I think is really important.