There are three things certain in life: death, taxes, and stock market volatility. That's just how it goes. When markets grow volatile and stocks begin to fall significantly, it's common to hear people encouraging investors to "buy the dip."
When done well, buying the dip can noticeably boost your investment returns in the long run. If you're wondering if buying the dip is a good investment strategy, the answer is yes. Here's why.
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Understand your cost basis
If you're a long-term investor and buying into great companies, sell-offs shouldn't alarm you. If anything, you can view them as an opportunity and a chance to lower your cost basis. Your cost basis is the average price of the shares you've purchased of a company or fund.
If you bought 10 shares of a company at $150 each, your cost basis would be $150. If the stock's price dropped to $100 and you bought 10 more shares, your new cost basis would be $125. Here's how the math works:
- 10 shares x $150 = $1,500
- 10 shares x $100 = $1,000
- $2,500/20 shares = $125 per share
Your cost basis matters, because it determines how much profit you receive when you eventually sell the shares. Two people could sell the same number of shares for the same price, but the person with a lower cost basis would collect a higher profit. If the above stock increased to $200 and you sold your 20 shares, you'd earn a return of $1,500. If another person's cost basis was $150 and they sold 20 shares, their return would only be $1,000.
You need cash to take advantage of dips
A large part of being able to take advantage of market dips is having cash (that doesn't include your emergency fund) on hand to use. There's no concrete answer to how much cash you should keep in your portfolio, but a good rule of thumb is to aim for at least 10%. If at all possible, you want to avoid selling assets to take advantage of market dips.
Let's use the Vanguard S&P 500 ETF as an example. In March 2020, during the early stages of the COVID-19 pandemic, the fund's price dropped to $210 per share at one point. If you had $2,100 on hand, you could have purchased 10 shares. As of May 18, 2022, the fund's price is just above $360, and those same 10 shares are now worth around $3,600. Having the cash on hand would've given you the opportunity to take advantage of that price dip and profit over $1,500.
Focus on the long term
If you're investing for the long run -- which you should be -- don't let short-term price dips negatively affect how you feel about an investment. History has shown that great companies will find ways to weather storms and thrive over time. If I liked Microsoft at $330 per share (its price early in Jan. 2022), then I should love it at $254 (its price as of May 18, 2022). Nothing fundamentally changed about the company or its future potential -- the stock has just been swept up in the broad market sell-off. Stay focused on the long term.
