Should I Invest Immediately After a Small Dip in the Stock Market?

This week, The Simple Dollar attempts to address challenging questions in personal finance by looking at both sides of the story and figuring out some of the factors you need to look at to make a decision.

Several times this year, the stock market has dipped more than 1% in a single day. If you read the advice of some writers, like in this article by Ben Stein, there is some strong encouragement out there that a dip in the stock market like that means it’s time to buy a broad-based index fund. On the other hand, if you follow the advice of other columns, like this one by Ben Stein, you’ll hear that market timing is bad.

Which is right and which is wrong? There’s not a really easy answer to this one, so let’s look at both sides.

Market’s Down? Buy!

If you look at the long term history of the stock market, stocks go up in value. There has never been a thirty year period where stocks are down, and over the entire twentieth century, the broad stock market increased in value 20,000%. Because of that, it’s reasonably safe to assume that stocks are a lucrative long-term investment.

Now, on any given day, if the stock market drops in value, you can effectively buy in at a cheaper price than the day before. Let’s say you could buy an index fund for $1,000 that included a bit of every stock on the New York Stock Exchange. Then, in one day, the market drops 4%. You can now buy that same share for $960 – it’s effectively a sale!

In other words, buying a low-cost index fund when the stock market drops is the equivalent of buying it on sale. Any time you can buy a solid long-term investment on sale – and it’s all legit – is a deal you shouldn’t pass up.

Ignore Timing and Stick With a Real Strategy

In a mathematically perfect world, the above scenario would be just fine. If the long term trend is up but the very short term trend is down, and you knew that for a fact, you really could clean up on the stock market. Unfortunately, it’s not all perfect like that.

For example, down days on the stock market have different meanings. A day where nothing much happens can be a slight down day, but devastating financial news can be a monster down day. There are all sorts of varieties of individual days on the stock market, and they may or may not be part of larger trends.

Since 1950, using the S&P 500 as an indicator, any random day has a 53.8% chance of being a positive day. There’s also a 54.1% chance that a down day will be followed by another down day and an up day will be followed by another up day. In other words, if you buy on a down day, the odds are better than half that the next day will also be a down day, which means you bought at an elevated price.

The market is effectively random on a day-to-day basis, so playing games like timing the market by buying when the market is down tend to offer not much reward (and often some loss) in exchange for the effort of playing the game. An intelligent investor will simply follow a “buy and hold” strategy or a dollar cost averaging strategy (by buying in at regular intervals, regardless of the market) and sitting back and ignoring the day-to-day changes in the stock market.

My Take

If time were not a factor, it might be a worthwhile endeavor to try the “buy when the market is down” approach over a long period of time. Due to the randomness of the day to day stock market, you wouldn’t gain a whole lot, but you might be able to eke out a small positive return, on the order of a fraction of a percent, over a long period of time (with possible bigger gains or a small loss over the shorter term).

However, the time investment to follow this strategy day in and day out would make it not worth one’s time, unless one did it on a fully automated basis.

To me, market timing makes the relatively volatile investment that is stocks even more volatile and thus not worth the time. I see no problem if you’re about to buy in and jump on board immediately after a down day, but to invest with such timing as a regular strategy probably won’t afford you much serious gain. There is perhaps a tiny gain to be made here, but not a significant one in terms of the time invested.

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20 thoughts on “Should I Invest Immediately After a Small Dip in the Stock Market?

  1. Frank says:

    If I already had a regular plan of investing (dollar-cost-averaging) AND there was an exceptionally bad day in the market AND I had some cash hanging around with no other purchase, I think it would be a wise time to buy. Trying to ONLY buy on down days would never work.

    Also, I don’t have a link to the statistic handy, but I believe that you can’t find a 10 year period in the market that doesn’t have a positive return- I could be wrong but I’ve had that in my head for a while. :)

  2. Dave says:

    @Frank:
    I agree. If you keep waiting for a serious correction to make an investment, you could miss many months of gains, and wind up worse than if you had just invested.
    That said, I’m buying financials now, because they’re quite the bargain. I’m also not particularly concerned if they go down tomorrow, or next week, or next month, because I’m not going to sell for decades.

  3. I think it’s always a temptation to try to time the market, but the market can be quite random in the short run.

    The best long term strategy is just to invest regularly so that you can average-down every time the market dips.
    -R

  4. sandycheeks says:

    Meh, when I put in a buy order directly @ Vanguard, it usually takes 3 days so I never know what the market will be doing. You’d have to be using a broker (who charges a fee) to attempt market-time, right?

  5. MoneyNing says:

    Buying on the dip is often very hard to do. So for most people, regular, automatic investments is the way to go!

  6. infix says:

    At this point I’m kind of afraid to do either: dollar cost average or buy on dips. Problem is there are some real systemic problems in the US financial system right now. The credit markets have begun to seize up again and a couple $Trillion in homeowner equity will be lost over the next 3 or 4 years. The US$ is at historic lows. It really seems the mountain of debt the the US economy has been based on for the last few years is now starting to fall over.

    I was planning on starting a Roth IRA with Vanguard before the end of the year, but at this point, I don’t know of any safe places to park money.

    BTW: for more on all this read:
    http://calculatedrisk.blogspot.com/

    It’s written by retired mortgage banking folks. I started reading it a year ago and they were talking about the subprime mortgage problem way before it ever showed up in the mainstream media.

  7. Rob in Madrid says:

    Congratulations Trent I just saw you broke the 20,000 reader barrier. Do you think you could add a feature as getrichslowly has done and allow “edible” comments

  8. dountoothers says:

    Zecco offers $0 stock trades (10 per month, 4.50 after that) with a min 2500 account balance. So no, you don’t have to pay much if you wanted to try some market timing of your own.

  9. S. B. says:

    “There has never been a thirty year period where stocks are down…”

    Yes, but also keep in mind that 30-year periods have historically been much better than simply not being down. By one study (that contained data starting before 1929 to present), the worst 30-year period returned about 8% annually! That is pretty amazing to think about.

    Of course, for shorter time periods, the record is much, much different.

  10. Johanna says:

    @sandycheeks: If you keep your “cash money” in a Vanguard money market fund, you can transfer money from there into your other Vanguard funds, and it arrives the same day. (At least, I think it does – it’s been a while since I’ve done this.)

  11. dountoothers says:

    How about a hybrid theory? Move money to your investment account on a regular basis (weekly, monthly, whatever) but only actually invest 98% of it.

    When the market corrects, throw in what you have saved up from the other 2%.

    Good point sandycheeks, Zecco does something simular. It’s called a money market fund sweep or something like that.

  12. Rick says:

    I’ve been dabbling with doing this a bit. I opened a Zecco account with some “play money”, and I try to buy on dips, and buy stocks I think will do well. So far, I’ve found it’s hit and miss. I feel like I’m learning a lot, so I’m not ready to give up active trading. It’s kinda fun, but it does take some time. If you don’t have time to spend researching stocks and the market, I’d suggest you just do regular investments (weekly, monthly) in an index fund. I do that as well with my retirement accounts. But if you have some time to spend researching the market, it certainly is pretty fun to try to time to market.

  13. DanMorin says:

    The U.S stock market has been inflated for many years with cheap money. An adjustment is necessary and liquidation (recession) must take place to return to P/E ratios according to customers (investors) preferences, including babyboomers wanting to retire (sell their investments). This time, lowering the interest rate will not make the stock market go higher; it will simply inflate the money supply again, and reduce the purchasing power of the dollar. The U.S. dollar already lost over 35% of its value this year alone, so you better have a good performing stock to offset that loss. Plus, you will be taxed on your artifical capital gain.

    The stock market has still a long way down to adjust. If you wish to understand more about business cycle, visit http://www.mises.org/.

  14. Tim says:

    sure, why not? if you are dollar cost averaging, you should be able to smooth out your long term horizon. If you dollar cost average when the market does dip, then all the better. Of course, the market could further dip and before it starts to increase again. Stick with good stocks that you researched. There is a lot of short selling going on now on a lot of unknowns, because there are lots of greedy bastards out there. Good, solid companies with good fundamentals who are taking a hit because the larger market is taking a hit, will still do well, so buy them.

    Second, diversify your portfolio.

  15. Zook says:

    If I had $5000 and wanted to buy QQQQ and wanted to buy it 5-times, I think when certain situations arise like the one we are dealing with right now, things change and so should your strategy. If you bought $1000 at $54.50 last week and this week saw it at $50.50, should you just but your $1000 or should you double or triple it? I am in the camp that as things change, so should you. Doesn’t mean you buy $4000 today, but maybe you buy $3000 using my example.

    It isn’t timing the market like we think [or at least I do] when I hear the term. You are dollar coast averaging and then a huge sale comes around and you change it up.

  16. rstlne says:

    I don’t usually wait for dips. My strategy is more along the lines of deciding what to invest in rather than when to invest. That said, I do take advantage of corrections by temporarily lowering my cash position.

  17. Zook says:

    rstlne-

    It’s not waiting around for dips [al least that's what I meant], but if one presents itself in the middle of buying stocks, than you should jump on it…

    I plan on buying more Google next Tuesday. I mean I just bought a share at $730 this past week. Now I might buy in 1-2 with Google at $665 as it is now a buying opportunity IMHO.

  18. If you are looking to invest,i mean invest well, maybe think outside the bubble ?

    Brazil is on of the Brick countries, actually second in rankings now, and the real estate, energy and foreign trade sectors are just swelling.

    Do your homework:
    http://groups.google.com/group/investinbrazil

    I learned a whole lot from this group and managed to earn 40%-60% annually in the real estate sector which is red hot right now.
    earn 35-50% annually on real estate, 50%-150% in foreign trade and the energy sector 100% – ???? who knows depends on yourself and amounts of money invested i guess……

    Besides a great excuse to actually visit Brazil and what could be better than a business trip?

    Whoever said cant mix business and pleasure was definitely wrong.

    Good Luck !

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