3 Critical Questions for Investors Before “Buying The Dip”

If you've stumbled into the comment section of any finance-related social media account lately, you've likely encountered numerous “buy the dip” comments. Retail investors seem to have universally adopted buying stocks on the decline as a sound investing strategy.

While there's nothing wrong with a good bargain, the truth is that this buy-the-dip mentality can be cancerous to your portfolio if it becomes your primary strategy for investing.

So how do you know when to buy the dip? Smart investors understand the power of allocating money regularly to the market, while also taking advantage of market pull backs to buy high-quality businesses on sale.

Before buying the dip, make sure you can answer these three questions.

Source: Getty Images.

Has the stock market declined in general?

The first indication of a buy-the-dip opportunity is if the market at-large has taken a breather. With the Nasdaq down around 9% so far in 2022, this one is likely all too familiar.

Market rotations offer excellent entry points into great companies since Wall Street is less concerned with business performance and more concerned with macro-economic factors. Some examples of recent pullbacks include the taper-tantrum of 2018, the COVID-fueled crash of March 2020, and the recent valuation reset driven by inflation fears and rising interest rates by the Fed.

These broad market pullbacks can offer great opportunities to buy incredible companies at attractive prices. Take for example Taiwan Semiconductor (NYSE: TSM), which posted revenue growth of 21% in its most recent quarter — yet the stock has declined 11% in the last two weeks on seemingly no company-specific news. A double digit price decline and a now very reasonable price-to-sales ratio of 30 for a company that commands over 50% of the world's semiconductor market share might just be a gift from the investing gods.

But that doesn't mean every business that's down offers the same opportunity. Investors need to be aware of any potential flaws or hits to the business that might also be responsible for the stocks decline.

Has the business' performance changed?

Whenever a stock dips, even amid a broader sell-off, investors should search for any company-specific news that might also be contributing to the decline.

The company's investor relations website is usually a good place to start. Companies will often release statements regarding the performance of their business outside of quarterly reporting if they think it cannot wait until the next earnings call.

Such reports need to be considered before deciding to buy on a dip. Pinterest (NYSE: PINS) for example, has seen its stock price fall almost 67% since it reported a decline in monthly active users (MAUs) in February of 2021.

Slowing growth in key performance indicators such as monthly active users (MAUs), revenue, or earnings may be a sign that investors are better off waiting on the sideline until there is a clearer picture of the business' overall growth or long-term performance.

Do you still believe in the investment thesis?

One of the most common, and often most painful, mistakes investors make is ignoring their original investment thesis — or worse, buying a stock without a thesis at all.

An investment thesis is a written analysis of why you believe the company to be a compelling investment. Think of it as a hypothesis that needs to be backed up with supporting research. (Remember your 8th grade science fair?)

Your thesis is vital to long-term conviction, so if you don't have one or no longer believe in your original thesis for a company, you really have no business buying it.

There is no price too cheap for a busted thesis. Peloton Interactive (NASDAQ: PTON) looks awfully inexpensive at a trailing twelve month price-to-sales ratio of 1.8, but considering the company recently announced they've halted production of their high-end home fitness bikes, raised their prices, and conducted mass lay-offs, this looks much more like a value trap than a buy-the-dip opportunity.

Your thesis acts like a north star on your journey of owning the company. Without it, you'll likely lack the conviction to hold through the inevitable roller coaster ride of market volatility.

Don't water the weeds

Buying the dip can propel your portfolio if you do it right, but smart investors should look to buy great businesses regularly, not just when they are down. Investors who only buy stocks in recent decline run the risk of filling their portfolios with mediocre businesses. Winning companies' stocks tend to go up more than they go down. So if you're going to buy the dip, be sure it's winners you're buying at a discount.

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Mark Blanks own shares of Pinterest. The Motley Fool owns and recommends Peloton Interactive, Pinterest, and Taiwan Semiconductor Manufacturing. The Motley Fool has a disclosure policy.

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