Published: 9.5.2022
No financial advice
The content, all information, illustrations and figures in this article are for illustrative and didactic purposes only. Under no circumstances may this article be construed as financial advice, investment recommendation or offer within the meaning of the Securities Trading Act. Investment in bank deposits, securities, investment funds, real estate and commodities is associated with high risks of loss, up to and including total loss. Full limitation of liability
Does it make sense to hold back cash to invest it during the next crash? I mean it makes sense, doesn’t it? Just as we prefer to buy groceries on sale, why shouldn’t we wait for stocks to go “on sale”?
But there is a price to be paid for keeping cash reserves. The money we hold back does not make us the gains that we expect from the stock market while we are waiting for the next crash.
Buying the Dip Simulation
I would like to show this with the application below. What does it show? The graphs show the performance of two portfolios.
The portfolios both buy an ETF based on the MSCI World index.
- Portfolio 1 buys shares every month for the total amount available.
- Portfolio 2 also buys shares each month, but holds back some percentage of the money as cash.
As soon as the index loses a certain percentage, Portfolio 2 buys the index with the accumulated cash reserves.
As much as I play with the numbers, I can’t find a setting where the buying the dip strategy makes more money.
A few comments on the simulation: For Portfolio 2 the first graph shows the sum of the index shares + the cash reserves. A limitation of the simulation is that it works with monthly figures. Although I don’t think it would look much different with more specific numbers, I wanted to mention it explicitly.
Literature
That buying the dip is not optimal for profit maximization is also the conclusion reached by Shohfi et al. (2021). They have investigated the buying the dip strategy for the SPY index.
They looked at how the return on investment of the strategy compared to the variance. That is, how much we would have earned with the strategy, and how much risk we would have had to endure for the profit.
This they have investigated for two scenarios. One with a single large sum at the beginning and the other for monthy inflows, e.g. a savings plan.
They considered investing all at once for the single large sum vs. spreading out the puchases into smaller chuncks when the index dropped some amount.
In the savings rate buying the dip scenario, all the money was held back and invested only when the index lost some amount.
Shohfi et al. (2021) come to a similar conclusion as me. Buying the dip is not a strategy to maximize the total return of your portfolio. Buy they also found that it could but used as a simple strategy to reduce the variance, e.g. risk, of portfolios.
Conclusion
Whether you want to buying the dip is up to you. But I think it is wrong to claim that you can maximize the profit with it.
This post is inspired by the analysis of the Dot-com Crash here: When Buying the Dip Doesn’t Work: An Analysis of the Dot-com Crash