Should you buy on the dip?
With the tragic events in Wuhan spreading fear and panic across the world, global stock markets retreated (albeit temporarily). Several investors, who have been waiting for a pull-back for most of 2019 were eager to jump in, and asked a familiar question, “Should I buy on the dip?” This is always a confusing question for us for a couple of reasons that we highlight below.
1) How do you know it is a dip?
First we need to define what a dip is. A “dip” is an action where you see a sharp correction in asset prices (of 5-10% for equity markets and perhaps 3-4% in fixed income markets), then a period (sometimes as short as a few days) of stability, and then a sharp move upward towards the original price point. Now the percentages we stated here can certainly be argued but essentially a dip is a move down, then sideways, then up. However, almost ironically, you don’t know something is a ‘dip’ until after the fact. For a movement to be called a ‘dip’ it has to complete itself, i.e. move back up. In essence, you can only define something as a dip after it’s too late to take advantage of it. So all you know in the first two phases of the potential ‘dip’ is that there has been a price correction, but you don’t know if the price will go back up.
Now, you might accuse us of pettifogging, and that the word ‘dip’ is just nomenclature. However, we don’t feel like many market participants treat it this way. We often see that there is an implicit assumption, in the mind of the investors we speak to, that prices will move back up. However, like in life, there are no guarantees in financial markets. So one must truly ask themselves, if the movement they are observing isn’t a dip, and is in fact a prolonged downturn, are they comfortable buying? In other words, say the asset you buy, could correct another 15-20% after you buy, would you still be comfortable owning it?
2) Price does not equate Value
Investors, ourselves included, constantly fall prey to anchoring (read the “The Art of Thinking Clearly”). When we buy a small amount of a stock, thinking we will buy more later but can’t bring ourselves to do it after significant appreciation because we can’t bear to pay so much more than we did earlier, we are being influenced by anchoring. Or when we refuse to sell a terrible investment because we paid so much more for it, we get thrown off by anchors we set in our mind.
We find this tendency to anchor often occurs in tandem with a ‘buy on the dip’ scenario. Let us give you an example using Alibaba’s price movements (as its a popular stock to gain exposure to China) which occurred during this ongoing coronavirus outbreak.
We can see from the chart that a dip was clearly established by peaking around ~$230 on the 14th of Jan, falling to a low of $205 on the 27th of Jan, and moving up from there. Several investors following the ‘buy on dip’ strategy may have bought at $205 thinking that this was a great price. Why? Because just a few days ago the stock was worth $230, so using that price as an anchor, they got a real bargain.
However if we stretch the chart out just a little bit, we observe the fallacy of the $230 anchor and the $205 bargain.
We can see that the stock had touched $205 just a few weeks ago in mid-December. So surely, if you were willing to buy shares at $205 in January you should have been just as willing to buy the prices at $205 in December. Not much changed about the company during that period and there were no earnings announcement. In fact, you could argue that in January, the company was in a worse situation due to the coronavirus outbreak and that Alibaba prospects in December were in fact better. The reality is the only reason one would buy in the January ‘dip’ was because the stock looked cheap relative to the $230 price. The number 205 itself tells you nothing about the value of the company nor does it tell you if it’s a good or bad time to buy. The anchoring effect at play here causes investors to conflate price and value, and when we see this happening we always remind our clients of the Warren Buffet quote:
“Price is what you pay, value is what you get.”
In Conclusion
If we move away from the ‘dip’ analogy, then declines in asset price can and do provide very good opportunities for buying, but only when you think the price reflects fair or cheap valuations. Relative valuations to recent highs/lows are irrelevant and using them to justify your decisions can just be a symptom of impatience.
Long-story short, all things being equal – a dip is not enough of a reason to buy.
Happy investing all! And for all our readers, especially the ones in Asia, stay healthy!