Opinion: ‘Buy Down’ Is A Horrible Stock Strategy – And These Charts Prove It
I have already explained why the purchase of the drop cannot beat the average cost in dollars, even if you were god. However, I feel like this article was a bit too extreme. Buy the Dip was defeated in one fell swoop. He never had a chance to fight. There was no last meal, no closing words, and no funeral procession that followed.
But today I’m going to change all that. Because today I’m going to give Buy the Dip the funeral it deserves and demonstrate without a reasonable doubt why this is such a terrible investment strategy.
For starters, let’s say you fell somewhere in history between 1920 and 2000 and needed to invest in the US SPX stock exchange,
for the next 20 years. You have the choice between two investment strategies:
- Average cost in dollars (ACD): You invest $ 100 per month for 20 years.
- Buy the dip: You save $ 100 each month in cash until the market drops below a certain amount from its all-time high (i.e. 10%, 20%, etc.) invest 100 $ each month until the market hits a new all-time high. At this point, you start storing money again until the next drop of the same size occurs. Rinse and repeat for the entire 20 year period.
The only other rule of this game is that you cannot enter and exit stocks. Once you make a purchase, you hold that inventory until the end of the period. So what would you choose? DCA or buy the dip?
Before we answer this question, let’s take a look at how Buy the Dip works so you can see it in action.
How does Buy the dip works
To visualize how the Buy the Dip strategy works, consider following it from 1970 to 1990 with a drawdown threshold of 40%. This means you’ll save money and only buy when the market is 40% below an all-time high. After that 40% drop, you keep buying each month until a new all-time high is hit. At the new all-time high, you repeat the process and start saving money again, waiting for the next 40% drop to happen.
You can see this in the graph below which shows the Buy the Dip cash balance over time (green line) and when it makes purchases (red dots):
What this shows is that from 1970 to 1974 you are saving money until the market is 40% below its all-time highs. This is where you finally invest that money after the 1974 crash. You then continue to invest $ 100 each month (just like DCA) until 1984. This is when the market eclipses its edge. high of December 1972 and you start saving money again.
If we were to visualize how Buy the Dip compared to DCA (i.e. buy every month) during this period, we would see that the Buy the Dip wallet would gain over time:
As you can see, Buy the Dip begins to outperform DCA as the market begins to decline in the early 1970s. Buy the Dip is then invested after the 1974 crash and holds that lead for the remainder of the period.
Why Buy the Dip wins little and loses a lot
As good as the 1970-1990 period was for Buy the Dip, its best performance against DCA was from 1963 to 1983. It was during this period that Buy the Dip outperformed DCA by 29% overall. , as shown in the graphic below:
Similar to our previous chart, Buy the Dip started saving money in 1963 and was only invested in the market during the 1974 downturn. This is when Buy the Dip took the lead. DCA that he never gives up. Although it may seem like I’m arguing for the Buy the Dip strategy, I am not. It turns out that this is a time when this strategy would have worked quite well.
Unfortunately, there are a lot more times when Buy the Dip doesn’t perform as well. For example, if you had followed Buy the Dip from 1980 to 2000 with a 50% drawdown threshold, you would have kept cash for the entire 20 years as the market soared higher:
Why does Buy the Dip stay in cash for 20 years? Because there is no 50% drop to buy during this period. As a result, Buy the Dip is never invested. And because it is never invested, DCA ends up surpassing it by 5 times ($ 120,000 versus $ 24,000) over 20 years. That’s a huge amount of underperformance.
While this is an extreme example, it highlights the main problem with Buy the Dip – it stays in cash for far too long.
And while it is in cash, the market tends to go up. As a result, you end up buying at much higher prices than if you had just bought from the start.
For example, imagine deciding not to buy until there is a 20% drop in the market. Now imagine that the market is doubling without such a drop. Even if the market fell 20% immediately, the prices would still be 60% higher than they were when you started investing. Therefore, when you buy the dip, you end up buying not at a 20% discount, but with a 60% premium.
This is why Buy the Dip is such a terrible investment strategy. When he wins he tends to win a little, but when he loses he can lose a lot.
This asymmetric performance profile is what makes it such a poor investment strategy. And if we look at a variety of falling buy thresholds, we can see why.
Does the size of the dip matter?
Considering what I have discussed so far, you might be wondering if the size of the downside you expect matters for this strategy. For example, is waiting for a 50% drop better or worse than waiting for a 10% drop? Well, it depends on what you mean by better.
Technically, you’re less likely to outperform DCA in the long run by waiting for smaller dips than by waiting for bigger dips. As the table below shows, the higher your drop point, the more likely you are to outperform DCA over a random 20-year period between 1920 and 2020:
This chart shows that there is approximately a one in four chance of beating DCA when using a Buy the Dip strategy with a 10-20% downside. If you were to use a 50% drop threshold, the chance of beating DCA increases to almost 40%. But it does not come without cost. Because while you are more likely to outperform DCA when using a higher drop threshold, you are also underperforming more (on average) as well.
As shown in the table below, the median amount of outperformance when using Buy the Dip for 20 years ranges from -5% to -13% depending on which downside you use (Note: negative outperformance is the same as an underperformance):
This means that if you looked at all 20-year time periods from 1920 to 2020 and followed Buy the Dip with a 10% downside, you would likely have underperformed the DCA by around 5% in total (that’s i.e. the median result). If you used a 50% dip threshold, you would likely have underperformed the DCA by about 13% in total.
If you look at the distribution of relative performance by falling threshold, we can get a better view of what’s going on. The chart below shows how well Buy the Dip outperforms DCA (in total) for each downside specified over all 20-year periods in the data.
So imagine we compare Buy the Dip to DCA from 1920 to 1940 using a 10% drop threshold. Then we do that for 1921 to 1941, 1922 to 1942, and so on until 2000 to 2020. After that, we do all these simulations again for a 20% drop threshold, 30% drop threshold. %, and so on up to 50% drop threshold.
Finally, we plot the performance distribution of Buy the Dip versus DCA on all these simulations:
As you will see, while a smaller drop point is less likely to outperform compared to a larger drop point, the size of its underperformance will also generally be smaller.
What this chart illustrates is that the bearish threshold you use determines the likelihood and extent of your outperformance (or underperformance) against DCA. As the bearish threshold increases, the outperformance curve flattens with the middle of the distribution shifting to the left (i.e. more negative on average). This means that when your bearish threshold increases, the outperformance is more extreme, but the underperformance is also more extreme.
From this chart, you can see why it may be worth waiting for larger lows, but only if you’re lucky. Because if you’re unlucky, be prepared to lose a lot to DCA.
The bottom line
While it may be intriguing to store money to buy the downside, the data above suggests that this strategy is unlikely to win in the long run. If you managed to buy the dive once, do your victory turn then come back to invest as soon as you can. While you may think you have the ability to sell time, I suggest attributing your trade to good luck and then moving on.
The reason Buy the Dip typically fails is simply because market lows, especially larger lows, are rare. With no dips to buy, Buy the Dip is just a 100% cash strategy, which is a terrible way to invest for the long term. More importantly, while large declines can generate larger returns, predicting them in advance is nearly impossible. So be careful before waiting for one because your wallet may run out.
Finally, while the analysis presented here has been done on US equities, you can generalize it to any asset class that is expected to have a positive long-term return.
If you want to argue that Buy the Dip is beating the DCA for an asset class that is diving a lot more than US stocks, then go for it. Because I don’t know about you, but I like to buy assets that tend to go up.