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Buying the Dip Strategy Might Not be Better than Buy and Hold Strategy

Waiting for a crash suffers from two problems.

Firstly, markets tend to be trending more than risk adjusting. Markets historically do not dip deep enough (the kind of dip everyone was expecting) for us to meaningfully profit from the crash.

Secondly, there is risk and therefore we hope that the market compensates us for the return. The premium that we can earn, in excess of the risk-free rate (also called the risk premium), has historically been high. If we sit in cash, we lose this.

A long time ago, I bring to your attention the performance of a buy-and-hold investor compared to a market-timer (read If you buy near market bottoms, you should do better than Buy and Hold right?).

The market-timer wins out, but not by much if you considered the effort. (of course, there are some nuances. Even though the annualized returns are 1-2%, these returns do result in a big impact when compounded over long periods of time).

The interesting thing about the research in my article was that the researcher went through this study with many different markets. The results were quite consistent across different stock markets.

Back in 2017, SVRN Asset Management gave some quantiative figures why waiting to buy the dip is a terrible strategy.

They simulated different ways you could wait for a dip and buy, and then sell over different time frames.

For example, you could wait until the market dips 10%, then you purchase. You would sell once your investments made it back to all time highs.

The chart above compares the cumulative excess (basically returns over cash) of a particular buy-the-dip strategy versus buy-and-hold.

The data of the return:

Buy-the-DipBuy-and-Hold
Annualized Returns2.2%/yr6.3%/yr
Standard Deviation15.7%18.6%
Sharpe Ratio0.140.34

The annualized returns of the Buy-the-Dip strategy was much lower than Buy-and-Hold. A higher standard deviation means the returns of the strategy can be more volatile, relative to the average return. The Buy-the-Dip definitely is less volatile.

But less volatile can be a bad thing because there are downwards volatility but there are also upwards volatility.

The Sharpe Ratio shows the returns per unit risk. Sharpe Ratio allows us to put into context the relationship of volatility and returns. A Sharpe Ratio of 0.14 means for 1% change in volatility, this would have yielded 0.14% in returns. The higher the Sharpe Ratio the better.

It seems Buy-and-Hold is better.

However, some of you would wonder whether there will be a situation when Buy-the-Dip is better.

SVRN laid that out as well.

They back tested the date from 1926 to 2016 over different drawdowns ( a 10% drawdown to 50% drawdown) and then holding over different durations (1 year, 3 years, 5 years)

It seems from the data, waiting for a 10-15% drawdown and 40-50% drawdown will yield you higher Sharpe Ratios.

The excess returns if you buy the dip over 20 to 35% drawdown is lower.

We also observe that the excess returns rises when the holding period is longer.

The data tells me:

  1. Almost all the Sharpe ratios and Annualized returns of different drawdown durations and holding periods were much worse than the buy-and-hold (6.3% a year and 0.34)
  2. Holding period is important. The time in the market allows us to capture the risk premiums
  3. If we want to wait for a big crash, it would still be worth it. But the crash has to be a big enough one. However, usually those crashes occur once every 20 to 30 years.
  4. But then again, we already have 2 greater than 35% crashes in the last 12 years. Still, according to this data, the Sharpe ratio of waiting for 35% crashes might not be better than a small dip

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Bob

Saturday 26th of December 2020

Hi,

This is so true.

I wonder just how many of the "warchest warriors" actually bought in at the March lows. All the signs were there, death on the streets, hospitals full, lockdowns, domestic and international travel ground to a halt, stockmarket off 35%, no vaccine and the human race was about to become extinct.

I haven't heard a single peep from the hitherto "warchest at 30%" guys.

Reckon they changed strategy to Fear of Loosing All and kept quiet......

Season's greetings.

Sinkie

Sunday 27th of December 2020

In the local context, there was at least 1 blogger who did start utilising his warchest from March (and wrote down his purchases with a 1 or 2 day lag).

In the US sphere, there are 3 or 4 analysts/ strategists that I have been following for 15 yrs. And all were banging the table to back up the truck & load up on stocks in late March/ early April. Which reinforced my own confidence & plan to roll out my warchest. But it was still hard as F... to do it. You have to expect further drops once you buy; there's no such thing as catching the bottom before or even as it occurs, except by pure luck.

My premise was simple: past pandemics & epidemics or even financial crises didn't stop markets looking out 3-5 yrs. And I shld grab the opportunity on assets with strong fundamentals & catalysts. Much easier if you're dealing with broad- market or sector etfs, rather than trying to identify individual companies.

Kyith

Saturday 26th of December 2020

I can tell you that i couldn't pull the trigger in March

Andy

Saturday 26th of December 2020

Great analysis. I personally believe that a buy-the-dip strategy is very theoretically due to the behavior gap (between our rules/system and our actual execution), decision-fatigue (buy the dips requires way more decision-making than buy-and-hold) and the fact that dips are easily defined in hindsight (backtesting) but more challenging to identify while they are happening. Waiting for too large of a dip might also result in our capital not being deployed at all while the bull market marches on. And it is always worth remembering that we don't make money in the markets by buying. We only make money by selling - and that is pure psychology and emotions. Whether we make money or not entirely depends on what we do once we have a position in our portfolio.

Kyith

Saturday 26th of December 2020

Hey Andy, Merry Xmas to you. I like the details you go into this. WE can have a systematic plan but we will just keep delaying it. I think it is more of a muscle. You have to keep buying the dips, be comfortable seeing the result so that you get more comfortable buying the dips. Then maybe the buy-the-dip strategy would be useful.

Sinkie

Saturday 26th of December 2020

From real life observations, people who hold all or most of their funds in cash tend not to be able to execute their buy-the-dip strategy properly. Psychology acts against them.

Those who can consistently practise buying-the-dips tend not to keep more than 50% of their portfolio in cash. In other words, they maintain about 50%-70% in risk assets.

They are better mentally to deploy their 30%-50% cash when the bigger dips come.

Kyith

Saturday 26th of December 2020

HI Sinkie, i fall into the camp that you talked about.

Humji Investor

Saturday 26th of December 2020

Do you think that this is true of the SG market as well? When I look at the STI index, it doesn't seem to reward buy and hold since it's been flat the last 10+ years and dividends are about 3-4%. Perhaps the data was looking at much longer periods?

Kyith

Saturday 26th of December 2020

Hi Humji Investor, if you invest in the local index, the index have not breach the all time highs of the 2007 yet.

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