Is buying the Dip a good investment strategy? | Smart Switch: Personal Finance

(Stefon Walters)

There are three sure things in life: death, taxes, and stock market volatility. Is that how it works. When markets become volatile and stocks start to drop significantly, it’s common to hear people encourage investors to “buy the dip.”

When done right, buying the dip can dramatically increase your long-term return on investment. If you are wondering if buying the dip is a good investment strategy, the answer is yes. This is why.

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Understand your cost base

If you’re a long-term investor buying big companies, selloffs shouldn’t alarm you. If anything, you can see them as an opportunity and a chance to reduce your cost base. Your cost basis is the average price of shares you have purchased from a company or fund.

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If you bought 10 shares of a company at $150 each, your base cost would be $150. If the stock price fell to $100 and you bought 10 more shares, your new cost basis would be $125. This is how the math works:

  • 10 shares x $150 = $1,500
  • 10 shares x $100 = $1,000
  • $2,500/20 shares = $125 per share

Your cost basis is important, because it determines the amount of profit you receive when you finally sell the stock. Two people could sell the same number of shares for the same price, but the person with a lower cost would make a higher profit. If the shares above rose to $200 and you sold your 20 shares, you would earn a return of $1,500. If someone else’s cost basis was $150 and he sold 20 shares, his return would be only $1,000.

You need cash to take advantage of the dips

A big part of being able to take advantage of market downturns is having cash (not including your emergency fund) on hand to use. There’s no hard and fast answer to how much cash you should have in your wallet, but a good rule of thumb is to aim for at least 10%. If possible, you want to avoid selling assets to take advantage of market declines.

let’s use the Vanguard S&P 500 ETF as an example. In March 2020, during the early stages of the COVID-19 pandemic, the fund’s price fell to $210 per share at one point. If you had $2,100 on hand, you could have bought 10 shares. As of May 18, 2022, the fund’s price is just above $360, and those same 10 shares are now worth about $3,600. Having the cash on hand would have given him the opportunity to take advantage of that price drop and make a profit of more than $1,500.

Focus on the long term

If you’re investing for the long term, which you should be, don’t let short-term price declines negatively affect how you feel about an investment. History has shown that great companies will find ways to weather the storms and prosper over time. if i liked Microsoft at $330 per share (its price at the beginning of January 2022), then I would love it at $254 (its price at May 18, 2022). Nothing fundamentally changed about the company or its future potential: the stock has just been dragged down by the market sell-off. Stay focused on the long term.

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Stefon Walters has positions in Microsoft and Vanguard S&P 500 ETFs. The Motley Fool holds positions and recommends Microsoft and Vanguard S&P 500 ETFs. The Motley Fool has a disclosure policy.

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