Whenever the market enters a correction phase, "Buy the Dip" often comes up as the investing mantra. As seen in previous market corrections, it's not so simple as just buying the dip. On the surface, buying the dip might sound like good advice. Every dip looks like a good buying opportunity, until the dip keeps dipping.
At what point do we know when it’s good enough to buy? Let's begin by exploring a 30% and 50% drawdown.
What are your annualised returns after buying during a 30% drawdown?
A 30% drawdown is normally a good sign to start deploying your capital. There’s more than a 50% chance that you’ll get more than 10% annualised returns.
What are your annualised returns after buying during a 50% drawdown?
Once the market drops by 50% or more, it almost certainly means it’s time to buy. More than 90% of the time, your annualised return would be upwards of 15%. A 50% drawdown doesn’t happen too often, which is why you should grab the opportunity when it presents itself.
What's The Catch?
As with many good things in life, some notable exceptions apply. An example is the Japanese stock market, which was still below its December 1989 highs over 30 years later at the end of 2020.
At the end of 2020, Russian stocks were down 50% and Greek stocks were down 98% from its 2008 highs.
With a few exceptions, most equity markets go up most of the time, even though there may be occasional periods of poor performance over longer time periods. Even U.S stocks had a lost decade from 2000-2010.
Are The Odds In Our Favour?
After analysing developed equity market returns across 39 countries from 1841 to 2019, researchers estimated that the probability of losing relative to inflation over a 30-year investment horizon was 12%. This means that there is roughly a 1 in 8 chance that you expect an investor in a particular equity market to see a loss of purchasing power over three decades.
There is a 7 in 8 chance that an equity market will grow its purchasing power over the long run.
“Fear has a greater grasp on human action that does the impressive weight of historical evidence.”
Conclusion
It's worth noting that this applies to the stock market as a whole, and not individual stocks. The wise thing to do is to divide your capital into 2 to 3 tranches. The first tranche could be deployed when the market falls 30%. Market means a broad-based market index like the S&P 500. Individual stocks carry company-specific risks and may not recover even when they fall.
“The time to buy is when there’s blood in the streets.”
Easier said than done. Majority of people don’t dare, do you?
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