Should I Invest 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.