Should you ‘buy the dip’ in stocks?

Should you ‘buy the dip’ in stocks?

Why you shouldn't "buy the dip", or: a basic explanation of the Efficient Market Hypothesis (EMH).

It’s tempting to see a major drop in the stock market and believe that you have enough information to make a fast profit.

Right before I started writing this article, the stock market dropped well over 4%, leading to social media exploding with small-time investors saying things like, “Buy the dip!”

It sounds like sound advice. If anything, it almost sounds obvious.

After all, if you buy when stocks dip, that should, if you’re guesstimating things correctly, mean that you’re getting stocks just like normal over time – but at a slightly better deal.

This makes you more money, right? If stocks were a good investment yesterday, and today they’re 4% cheaper, then you’re just grabbing a 4% better deal, right?

Not quite.

In fact, this tempting approach is statistically more likely to cost you than earn extra. In fact, since investors started saying “buy the dip”, stocks are down another 4% – and we could be on the verge of a substantial correction.

Fundamentally, “buy the dip” is a bad strategy based on an economic illusion.

As they say, “If it’s too good to be true…”

The hidden assumptions of “buy the dip”

“Buy the dip” has a lot of built-in assumptions that you can’t statistically assume over time without getting seriously burned.

Let’s break them down:

  • Market type assumption. You’re assuming this is a dip and not the start of a bear market or at least a major correction. Miss the boat and you’ll get slaughtered – rather than get a few extra percentage points to your total return. The potential risks here are bigger than the modest potential payoff.
  • Peak dip assumption. You’re assuming that buying the dip now is better than buying the dip later. If the dip is still dipping, you might time it incorrectly. This is the irony of the entire cliché.
  • Rejecting previous prices assumption. You’re assuming that buying the dip now is better than buying into the market earlier with that same available money. This one is harder to see. Think of it this way: would you rather buy at a slight dip from 26,000 or would you rather buy at 20,000 and reinvest along the way? You’re assuming that this is the right time to buy stocks with your available capital – and not some earlier time. I’ll explain this assumption more in depth below.

The ideas discussed immediately above are the basic assumptions of the “buy the dip” strategy. They might seem innocent but they can literally wipe out decades of savings because of several extremely important economic principles.

Let’s look at the main principle that shatters these bad assumptions: the efficient market hypothesis.

WARNING: Ignoring boring concepts will put you at a disadvantage

Even if you find this to be mind-numbingly boring (most people would agree that it is), if you have any desire to save for retirement or find almost any level of financial independence, it’s an idea you need to understand as much as possible.

This is the kind of financial and economic concept that every high-school student and college student should be deeply familiar with before they graduate. As I’ve written before, teaching financial concepts like this would change society completely. Unfortunately, the ideas are largely ignored.

Think of articles like this as the broccoli of self-help content. They’re not fun to consume but you’ll be better off if you do.

So grab a cup of coffee or tea, read the article, and feel free to contact me to discuss it further – or browse around the Internet to read some more. It’s important and about way more than just “buy the dip” analysis.

Extremely important concept: “Efficient market hypothesis”

Let’s back up a bit.

To understand why you can’t beat the market with tactics like the ones discussed above, we need to understand a concept called the “efficient market hypothesis (EMH).”

Effectively, the efficient market hypothesis (EMH) is the idea that asset prices fully “account” for all “known” information.

Without getting lost in the weeds, the hypothesis claims that, roughly, the market is already accounting for everything we know about the market.

In other words, if you think a downturn is coming, the market is already priced for what it believes is the likelihood of one – so gambling on a future bear market will probably not make money, because the market has already accounted for that prediction as well.

There’s a reason Google is priced higher than a failing grocery store chain. The market is already pricing in the gamble that Google has better long-term growth likelihood than the failing grocery chain, to put it simply.

This notion of the market already pricing predictions is confusing to people.

Most tend to think that investing is about picking winners more often than picking losers. This isn’t remotely true.

In fact, this isn’t true any more than the idea that sports gambling is about just picking winners – if you pick winners of football matches 75% of the time, you will probably still lose money because a bunch of other gamblers made those same predictions – meaning the odds aren’t always going to be 50-50. If anything, after fees, you’re effectively going to almost always lose money gambling over time.

The same thing goes for stocks. You think Coca-Cola is a good bet? So do billions and billions of investor dollars. You think Google is a good bet? So do billions and billions of investor dollars.

Market prices reflect market predictions, effectively. So whenever you are gambling on the basis of a prediction you are making, so are all of the other people buying, selling, holding – or considering those things – that asset.

It’s not enough to get a prediction right. There’s a lot more going on. That simplistic “good prediction” understanding of investing is tempting and destructive.

The more available information becomes, the more efficient markets become

No one person or organization decides what something is priced in the market. The stock market, in particular, is just a large collection of people buying and selling identical assets to other investors via bidding.

This means that prices simply reflect whatever supply and demand for the priced asset reflect at the time – if people suddenly stop selling, prices might go up – assuming there’s the same number of people trying to buy with the same intensity as before.

This means that prices go up and down for individual assets on the basis of the investors trying to buy, hold, or sell the assets. So the prices reflect the desires being acted upon by the investors – market prices respond to what all of the investors think they are worth.

This understanding that markets reflect the beliefs of huge number of investors is important. Markets don’t reflect random people or the average investor – they reflect the applied beliefs of investors with the most money being gambled on the asset, as well. The more exposure to the asset one has, the more one’s acted-upon beliefs impact its price.

Market prices reflect what investors know about the market. Information being released impacts prices. Prices reflect known information – not just information, but known information. Or, more technically (and philosophically accurate, for lack of better word), prices reflect believed information.

This makes markets brutal, powerful, and very fast responders to events, analysis, and the learned experience of the most powerful investors. In other words, markets are elaborate social pricing machines based on known information about the assets in question.

Put simply, prices are the market’s reflection of the known information about the asset at that particular time. This is important. If anything, understanding this is key to understanding everything else discussed on this page.

As information continues to spread faster and faster with innovations like the Internet, being able to have an “information edge” becomes increasingly difficult to the point of being impossible.

It would have been easier to outperform the stock market in 1940 than it is in 2018. Information simply spreads too fast and is too widely available to beat everyone else. Having an information advantage is difficult when insider trading is illegal and Indonesian street vendors have more information than the Library of Alexandria in their pocket computers.

Even Benjamin Graham, the father of value investing, (which Warren Buffet based his life work on), eventually came to concede to the efficiency of public markets. He wrote in 1976, literally 42 years ago and well before the Internet made things worse:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham and Dodd” was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I’m on the side of the “efficient market” school of thought now generally accepted by the professors.”

If Graham thought it was tough then, he would have been a vigorous supporter of the efficient market hypothesis now. As everyone should be.

The market is a massive pricing calculator involving almost all human wisdom

Understanding markets as nothing more than an incredibly massive, incredibly comprehensive series of pricing mechanisms is the first step towards financial humility.

People who misunderstand the EMH almost always misunderstand the first step: the market is just a big pricing machine accounting for nearly all known information. So unless you have some massive, massive information advantage (like insider trading, or some kind of elaborate expertise in a particular industry mixed with the ability to understand utterly in-depth financial valuations), you won’t outperform the market. Period.

So you won’t do better if you buy the dip than if you don’t. You won’t do better if you refuse to invest during a dip. You won’t do better no matter what you do – not risk-adjusted.

This doesn’t mean you’re helpless. Make sure to read the end of this article if you’d like to skip to the more optimistic interpretation of these concepts.

You and I aren’t nearly as smart as we’d like to be. Our comically tiny ability to comprehend the Universe pales in comparison to countless investors using countless unique angles coming together in the total capital markets – with almost everyone looking for the slightest advantage.

Why this mumbo-jumbo market pricing stuff matters

You can’t beat the stock market, risk-adjusted.

Even if you predict all kinds of things correctly, that’s not the point – you’ll eventually get a couple wrong and those will ruin your numbers – putting you back where you started, or worse. If you do get lucky, you didn’t get lucky on a risk-adjusted level – meaning, well, you were lucky, not better informed than the market at large.

And getting lucky isn’t the same thing as having a superior strategy.

Studies repeatedly confirm this EMH framework. So do surveys. So does, well, almost all known evidence. And, it’s even getting worse.

This bleak conclusion makes sense – after all, the market is nothing more than a pricing machine, so the more efficient (ie, the more informed the market is – which during the Information Age is going to be pretty damned informed) the market, the less likely you are to beat it.

For anyone keeping score on how well information spreads these days, you have effectively no chance of beating the market, risk-adjusted. Period. Sorry. End of story.

Directly tying this into ‘buy the dip’ theory

‘Buy the dip’ sounds good, but like I wrote earlier, it’s based on some assumptions that don’t make risk-adjusted sense. The biggest one is that you’re assuming the dip isn’t the beginning of a crash. Imagine if instead of “buy the dip” we said, “buy the stocks right before the bear market wipes you out for about 10 years.” Doesn’t sounds as clever, does it?

Of course, almost never will the dip end up a bear market. Nine times out of ten, you’ll avoid that. But it’s that one out of ten that wipes out your statistical advantage. That’s the part that confuses people. You’re not trying to usually beat the market – you’re trying to beat the market on a risk-adjusted level – which is economically impossible.

The same concept applies to the other assumption: the notion that if you can “buy the dip” then you’re buying it with resources that supposedly you had access to beforehand, otherwise you would just say “buy” and not “buy the dip.” The reference to taking advantage of a specific opportunity in the market and not just buying consistently suggests you’ve been sitting on the money.

If you sit on money you want to invest in public markets at some point because you want to outperform it, you’re missing the economic point – you’re never going to perform better sitting on the sides. Think about how many people thought the market was “too” expensive a couple of years ago – they’ve lost an incredible amount of wealth because of that view.

What this does NOT mean

I spent a lot of time writing about these concepts, but i want to make sure what I’m saying isn’t misunderstood as another set of arguments. Here’s a quick clarification. I’m not saying anything bolded in the section below:

  • Nobody can beat the market. I’m not saying that it’s impossible to beat the market, necessarily. You can beat the market – if you have what’s called an “informational advantage.” Since the markets reflect known information – information that is known by the market – the way to beat it is to have information the market doesn’t have. That’s why insider trading is illegal – and it’s how congressmen often get rich with all of their special knowledge they can abuse.
  • Private markets are the same. Private markets are utterly different. It’s very difficult but still very possible to make more money running a business than the average business earns. This is about publicly traded systems with extremely high levels of knowledge. Private markets are extremely different beasts altogether.
  • The market is “perfectly” efficient. I’m not saying the market is perfectly efficient. Reflexivity, the idea that explains why people often overreact to known information, shows us that markets aren’t perfectly efficient. But they’re pretty damn close – especially when you account for trading fees and the lost opportunity cost of the time spent investing. My view is what’s called the “weak” efficient market hypothesis – it’s not perfect, but it’s pretty close.
  • EMH is essentially financial populism. A lot of investors love to pretend it’s contrarian and anti-mob to reject EMH. They seem to think that EMH is a belief in crowds. That’s not quite fair. It’s a belief that markets are better information digests and pricing machines than any one person or organization – that’s for sure.

Avoiding mistakes is 99% of investing. But enough about the bad news. Let’s look at some interesting applications of these ideas that will make you money.

You can’t outperform the market, but you CAN outperform the experts

Now here’s the cool part. You can invest better than almost every financial genius on earth in a couple of surprisingly simple steps.

You can invest better than the billionaires, the stock-market gurus, the bankers, the college endowment investment managers, the financial planners – you can outperform almost all of them over time.

The way is simple. They’re all trying to outperform the market. This, on average, causes nearly every last blasted one of them to dramatically underperform the market for the reasons explained above.

So if you just hook up your portfolio to track the market as cheaply and as consistently as possible, you’ll outperform the experts – by default.

All you have to do:

  • Minimize your fees with funds like Vanguard.
  • Get as much broad market exposure as possible with funds like Vanguard.
  • Invest your capital as soon as its available without any attempt to time the market.
  • Rebalance regularly, like every quarter.

Do this and you’ll outperform almost every mutual fund on earth over time. You’ll outperform almost every equity hedge fund. You’ll outperform almost every individual investor.

And you’ll do it because of your humility.

Vanguard is an organization that exists so that any ‘profits’ get passed back to the funds themselves, meaning they are as low fee as is legally and economically possible – in general. Their index funds just try to not beat the market – they’re based on the assumption that the market is essentially always priced the best possible way based on all known info.

And it works. Vanguard slaughters the competition easily. It’s almost embarrassing for the experts. I’ll be writing about this more down the road. Make sure to sign up for my newsletter if you’d like to read more. It’s boring, but it’s powerful because it’s true.

Final thoughts

Don’t try to buy the dip. Don’t try to make financial gambles on the basis of your market predictions. Build a simple portfolio like the one described above. Don’t fight the market – let it carry you itself.

Buy the market regularly regardless of the news. Sometimes, you’ll buy while the market is rising. Sometimes, you’ll buy while the market is falling. Sometimes, you’ll buy while the market is flat. Regardless, over time, your portfolio will get better, and your returns stronger.

Most importantly, perhaps: use economic literacy to avoid big mistakes that you’ll regret for the rest of your life.