Why shopping for a market downturn will be good and dangerous

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“Buying the dip” is an investment thesis often touted by stock traders and financial advisers for the purpose of generating returns.

The consideration is that when a stock index like the S&P 500 is depreciating in value, this is a good time to buy as stocks can be bought at a discount. Investors then reap the financial benefits when stocks rebound.

The market exodus on Monday – and the recovery on Tuesday – are a prime example of this.

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The Dow Jones Industrial Average stock index plunged 2.1% on Monday, its worst day since October, amid investor fears over the Covid-19 delta variant. However, the market rebounded on Tuesday, with the Dow closing 1.6% higher.

“The Dip purchase has long been successful,” said Philip Chao, certified financial planner, principal and chief investment officer at Experiential Wealth of Cabin John, Maryland.

However, experts warn that investors who are not careful could do themselves long-term harm with this strategy.

Shares and Incentives

The current environment generally supports equity investing, Chao said. Low interest rates make stocks more attractive compared to other typical asset classes such as cash and bonds.

“There are many reasons stocks continue to do well,” said Chao.

Many investors, especially those able to keep their jobs during the pandemic, may have the option to buy a little more now as the market subsides. Government stimulus funds helped replenish savings that had already been boosted by limited spending.

For example, personal income rose 21% in March, the largest increase on record, largely due to $ 1,400 stimulus checks issued to U.S. households.

Americans’ personal savings rate of 12.4% in May was lower than any other month during the pandemic, but still higher than since the early 1980s.

“All of that money is looking for a place to go,” said Dan Egan, vice president of behavioral finance and investing at Betterment. “If there’s a major slump in the market, this is a good use of that godsend.”

Investor Psychology

However, investor psychology can create an urge to sell – rather than buy – when the market pulls back. Unfortunately, that impulse is likely to cost her.

An investor who invested $ 10,000 in the S&P 500 in early 2001 – and has stayed invested since – would have made $ 42,231 two decades later for an annual return of 7.47%, according to JP Morgan Asset Management.

However, an investor who pulled out and missed the 10 best market days during that period would have only $ 19,347, an annual return of 3.35%, JP Morgan pointed out.

You can wait a long time for a significant drop while the market rises.

Dan Egan

Vice President for Behavioral Finance and Investments at Betterment

Seven of the best days in the market came within just two weeks of the 10 worst – meaning even a short-lived exit could have proven costly.

Investors who buy during a market escape should know that stocks can fall further before they recover.

“Just because you’ve been waiting for it to go down 10% doesn’t mean it can’t go down 20%,” Egan said.

Reservations

However, there are reservations about purchasing the dip.

A big one: buying the dip is unlikely to be a long-term financial gain for people who are uninvested, but instead are sitting on a pile of cash waiting for a market sell-off to move their money around.

Such investors can get a positive emotional return (knowing they didn’t buy at the top of the market). But they also missed the rally on the way up, which meant they haven’t benefited from stock returns in the meantime.

“You can wait a long time for a significant decline while the market is rising,” Egan said.

Investors will be most successful with the strategy if they already have an investment plan in place and have a little extra cash to invest in opportunistic investments, Chao said.

Investors can take a more regulated approach by running the piecemeal strategy, he said. For example, if an investor has $ 10,000 in cash, they can invest $ 2,000 at once if there is a 2% or 3% sell-off, rather than all at once.

The origin of the funds is also important, added Chao. For example, withdrawing money from an emergency fund to buy stocks during a pullback would probably be a bad idea.

In addition, pursuing the strategy with a single company stock – as opposed to an index made up of a basket of stocks – is much riskier, he said.

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