Buying the dip: How much could it hurt?

On Tuesday night, tech stocks start to fall. The next day, Mark Savvy, an experienced investor, goes to work like normal. As he settles in, he’s greeted by one of his co-workers, John Derval.

“Did you catch the news?” John says, rolling his chair over to Mark’s desk. Mark notices that John is speaking excitedly, and his hands keep fidgeting.

“What happened?” Mark replies, calmly going about his duties.

“Tech stocks are down,” John says, licking his lips. “You gotta buy the dip, man.”

Mark smiles. John’s been reading a lot of influencers lately. Over his shoulder on his computer, Mark can see a browser opened up to an article with a headline reading “10 Stocks to buy RIGHT NOW!”

“Thanks John, but I’m all set.”

John scoffs. “But, you’re missing out on a great opportunity. Stocks are hugely undervalued right now!” His brow furrows, and his hands start to fidget more than before. "It's time to bust that piggy bank open!"

Photo by Fabian Blank on Unsplash

This type of conversation has happened several times in the past few months, and has never seemed to help John reach his financial goals. Mark has an idea and pulls his chair up to John and asks three important questions:

How much does it really cost to “buy the dip?”

Academics and institutional investors have known for awhile that actively trading securities costs much more than the average person is led to believe. Even today, when apps advertise “$0 transaction fees” the truth is that people are paying through greater inefficiency.

Every transaction, each buy and sell order, is an opportunity for inefficiency. Like a small leak in a boat’s hull, one won’t sink a ship, but over time many will end up dragging the boat down.

People have begun to take notice of this, and in recent history have been fleeing actively managed funds, and into passively managed funds with low turnover and expenses.

Let’s take a look at how these transaction fees play out when “Buying the Dip.”

How many transactions will need to be performed?

1 – Assets must be sold to free up cash to Buy the Dip

2 – Purchase the stocks you desire

3 – At some point in the future, the stock must be sold to lock in profit

4 – Assets must be purchased to return the portfolio to its intended allocation

That’s four times when money must be spent. So, profits must be great enough to exceed those transaction costs, on top of which investors risk the possibility that they’ll have to buy their initial assets back at a more expensive price.

On top of this, investors also face another major drag: taxes.

Each time that investors sell assets they’ll need to pay capital gains tax. At best this creates another potential drag on the return that investors hope to get. At worst, it will lead to very unwelcome surprises come tax time.

“Buying the dip” is a form of active trading, and statistics show that those who actively manage their portfolios end up getting returns that are 40% lower than those who passively manage their funds.

How do you know the stocks are undervalued?

Mark asks this question because he understands the Efficient Market Hypothesis.

In short, academics and Nobel Prize winners have come to understand that at any point in time, the stock market funnels information so efficiently, that stocks are always accurately priced.

While John might be excited about the prices going down, it’s important to also ask: why are people selling?

Could the sellers possibly know something that John doesn’t know?

Could that information potentially spell further losses for John rather than potential gains?

What is your overall investment strategy?

A well thought out strategy doesn’t need to be thrown out the window at the first sign of a small change in the market. In fact, chasing the dip can seriously lead a portfolio astray.

As mentioned before, economists have discovered that a passive investment style, trying to match the market rather than beat it, actually leads to greater returns. One of the primary ways to implement this strategy is through mutual funds.

Mutual funds, unlike individual stocks, are traded at the end of the day. What this means for someone trying to “buy the dip” is that if they’re following the advice of many well-known economists, by the time their order goes through, they’ve already missed the dip.

At the end of the day, buying the dip is difficult to execute in a timely fashion, and the very process of it throws the investor’s overall portfolio off-kilter, potentially exposing them to more risk for fewer returns.

Is there a better way?

John asks this question quietly.

Mark reaches over and pats him on the shoulder.

“Yes, yes there is. Have you noticed that since I came in today you haven’t stopped fidgeting?”

John looks down at his hands, “Well, yeah. It’s pretty stressful. I had to move a lot of money around this morning. I dipped into our vacation fund.”

Mark nods compassionately. “I know what you mean. And it’s hard to know if the market will go back up in time for your vacation.”

John laughs, “Yeah, my wife won’t be too happy if we can’t take the trip we’ve been planning.”

Mark chuckles, “That’s definitely true. And not something I’m about to risk for my family. I’m already hitting all the benchmarks my financial planner has set for me. Why would I risk throwing that out the window? Look,” Mark raised his hand, “I’m not fidgeting at all. I’ve actually had a really relaxing morning.”

John sighed, “I’ve had a really stressful morning. And from what you’ve told me, the fees are eating up any potential profit anyway. So…”

Mark smiles encouragingly, “So you’ve learned something today. It hasn’t been a complete waste. This led to a really good discussion.”

“I just wish I didn’t have to spend so much money on these lessons.”

Mark thinks for a second before replying, “I guess that’s why I pay my advisor. So I don’t have to learn things the hard way.”

If you’re wondering how you could avoid expensive lessons taught through losses, click here to sign up for a free Bronze Account. A licensed advisor will reach out to set up a meeting and show you some ways you can optimize your finances right now.

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