The Buying On Dips Strategy - Does It Work?

Summary

• Market volatility, spurred in part by uncertainties over what Trump will actually do, has increased.
• As a result, a number of articles have been written on whether to "buy on dips."
• This strategy, along with others are examined.

Elliott R. Morss ©All Rights Reserved

Introduction

Since stock markets collapsed in 2008, there has been a spate of articles on whether to buy on dips. Anecdotal stories abound. I have a friend who claims he sold near the bottom in 2009 and bought similar equities shortly thereafter. He says this gave him a nice capital loss to put against the gains he made over the next few years. Oh, did he really? And two weeks ago, many people were crowing about having just bought on dips. That was fine, until last week.

So what do we know? Since 1970 and through 2017, the compound annual growth rate of the S&P 500 was 7.6%. That suggests that whether you bought on dips or just bought randomly, you would have done well. But note, as the following chart suggests, there have been numerous “dips” and “peaks.” Which dips to buy on? Any “buying on dips” strategy worth considering must include “timing conditions.”

S&P 500: 2009 - 2016

Source: Macrotrends

Buying on Dips

Investors had a big decision to make earlier this month, after a wave of selling sparked a long-anticipated correction in U.S. stocks. Should they sit on their hands and do nothing or use the opportunity to buy the dip?

Research by Schroders has found that over the last 30 years, the U.S. market returned an average of 25% in the 12 months after drops. Sanghamitra Saha, writing for Zacks, argues you should first look at future economic prospects and if they are good, buy on dips.

D.M. Martins Research has also done research on this question. Their findings:

Buying stocks on the dip would have been a superior strategy to buying and holding the diversified stock index since 1996. Using our buy on dips strategy, the annual return over the 20-year period would have been 15.2% vs. the Dow Jones Industrial Index’s 12.4%. This seemingly small difference of 2.8% per year, compounded over the period, would have been responsible for creating an extra $6,444 in the original buy on dip portfolio, representing a whopping 62% of the portfolio's final value of $16,817.

Trend Following

John Reese’s Validea, a quantitative investment research firm that models great investors, has an impressive performance record. Since inception in 2003, an aggregate of the guru-based portfolios it runs on its website has had a compounded annual growth rate of 6.22% versus the S&P 500’s 3.88%.

Validea has looked carefully at the “buy on the dip/sell on upturns” strategy and instead has tested a nearly completely opposite approach. It calls it a “trend following strategy." Using weekly data, it calculated moving averages. It simulated what happens by selling when the market closed below both a short and longer term moving average. It also calculated what happens if you back when the market closed above a shorter term average. Validea applies this trend following model to nearly 50 different asset classes and investment vehicles. So, for example, stocks, bonds, gold, commodities, sectors, investment styles and size and its guru models. The findings:

The returns on the trend following strategy are superior to the buy/hold returns on about 85% of all investment vehicles since inception.

However, Justin Carbonneau of Validea adds the following caution:

For investors who can buy an asset class, like the S&P 500 and hold it for 20-30 years, buy and hold probably is better. However, as we know, many investors don’t have the ability to deal with the bear markets when they come around and they end up hurting their returns by buying and selling at the wrong time. So for some investors who know this, a trend following system can help as it is a systematic way to move in and out of the market, and the goal of the trend following system is to lessen the drawdowns, when they occur by being out of the asset class before the very worst of a decline, but also be in the asset class once the uptrend is re-established. There is a taxable consideration as well here in that using taxable money with a trend following system may not be efficient because you would be moving in and out, and as a result you may end up taking gains.

Trend Following Versus Buy and Hold

Justin concludes:

I don’t want to paint this as some perfect investment strategy or something like that. Like any model or investment approach, there will be periods when it works and when it doesn’t, but the data is very compelling. However, a model like this introduces another touch point for investors. For many investors the more they fiddle with stuff, the more potential there is for their emotions to get involved, particularly when a strategy doesn’t work, so it takes a very disciplined investor to utilize something like this effectively.

Related to the point above, any trend following system has the ability to get whipsawed – this happens a lot. So anyone following a system like this would have to understand that going in. Where the system excels, and makes up for those whipsawing effects, it is protecting the investor on the downside once a bear market comes.

Conclusions

All of the above is interesting. But I offer several caveats on the “buy on dips,” and “trend following” systems.

• I take to heart the thesis of Paul Samuelson and Burton Malkiel’s book “A Random Walk Down Wall Street” – that nearly all new information is almost instantly reflected in stock prices. That suggests that if there is a system that regularly beats the market, enough people will start using it and soon eliminate its investment “edge.”
• As an individual investor, I still remain uncertain on just which dips to buy on.
• And I am not likely to start developing my own moving averages to guide my equity purchases and sales.
• Of course, I could pay someone “to buy on dips” or “follow trends” for me. However, my investments are too important to me to entrust them to someone else. If mistakes are made, I want them to be my mistakes.

The Trump Presidency has increased investment risks. So I regularly ask myself if I feel confident enough about my portfolio so as to not feel too bad if there is a significant downturn.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Briar]

I remember someone asking Buffett if he had a formula. He replied that he would love to have one but had never found one that worked. That was 30years ago. I strongly suspect he still hasn’t found one.

Buying on the dip is a form of anchoring to the market and price. If you don’t have an idea what something is worth, a dip won’t rescue you. It is a lazy person’s way to loose money.

The wise investor will assume that the efficient market reflects what is known, and that one should accept that until they have solid reason to know better. Why do you think Buffett has a long history of not revealing what he is doing until he has to?

[Elliott R. Morss]

I start from the efficient market assumption, both because it is probably the best starting point and because it keeps me humble.

I marvel at how Peter Lynch and Validea (and Tiger Woods) have been able to do so well for so long http://bit.ly/29GceLl.

[Briar]

Elliott, you are quite right to base your humbleness on the EMH, properly understood. When we digress from it without having done our homework we rely on luck.

[KYSANMAN]

Interesting points. Could this be called "Momentum investing"? Years ago I tried that strategy with hot IBD stocks and a professional investor. Gave him two years and his returns were mediocre.
I try to use a combination of technical and fundamental screens, but rely mostly on fundamentals. It is working for now. A lot better with Trump than Obama or Bush, or even Clinton. Investing is hard and requires courage, study and intuition. Luck beats them all sometimes, in the short term.

[sheepdip]

You may think it the route to follow until you run out of money.