When Buying the Dips is Terrible Advice

 

You have heard the sayings before, “buy the dips”, “average down”, “buy the lows”.  Well this is terrible advice at worst, and bad advice at best.  The origin of that statement goes back to sales training courses for brokers and stock promoters, when they were taught that price drops are a good time to contact their clients and sell them stocks at “cheaper prices” to drum up commissions for the brokerage house.

If you look at a chart of the S&P 500 index, you might ascertain the broker advice to be in your best interest, but try pulling up a chart of a company called Bryex, or Enron.  You can’t, because it is bankrupt.  Now imagine buying those dips.

 

 The problem with buying the dips is two fold:

1 – Dip buying assumes that the stock price is lower and in turn undervalued compared to before. 

This is incorrect, the price is lower because the market has priced in a decrease in value, so it is not actually a boxing day blow out sale, but a possible signal of change in perceived value – a potential much bigger problem.  This brings us to a pivotal moment about valuation models.  What is a stock worth?  Whatever someone is willing to pay for it.

2 – There are a lot more companies that have went bankrupt in the past than there are in existence at the moment.  

This is key!  There is a bias in pulling up charts of companies listed on the exchange and saying hey look, buying the dips works!  The bias is that these stocks actually exist.  Try looking at a chart of a company that has gone under and picture yourself buying the lows there.  It’s a great way to lose ALL of your money.  Try it here. (DOH!)

 

When buying the dips actually makes sense:

The low buying philosophy has some merit when you actually apply it to passive index funds, which go out and buy all the stocks in the index they track.

If you want to purchase the entire S&P500 index you would buy the SPY ETF which buys all 500 stocks to mirror the index (and costs just $208 a share as of today).  Why does it work here?

Because all your eggs are not in one basket, but distributed across 500 companies.  So one stock going bankrupt will only represent a 0.2% hit.  Insignificant.  This is the concept of spreading your assets around to achieve diversification.  Purchasing at the lows works very well for passive investors who have a LONG TERM view, but you may have to hold through some turbulence and noise, which can sometimes last for years on end.

If you want to buy the dips and sell them shortly afterward, you are a trader at heart and should apply some more sophisticated analysis and trade execution techniques.

We can teach you these techniques in our Trading Foundations Course.

Good luck and good trading.

 

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