Is it finally time to buy the dip?
We’ll get back to the timing issue here shortly, but the biggest mistake that most of us make when even asking this question is that we tend to think of it as one decision that we have to make at a single instance of time.
We think of it as an either/or decision and that will be measured by whether or not prices go up or down once we pull the trigger.
In fact, nothing could be further from the truth. Successful investors think in terms of probabilities spread out over a period of time rather than thinking in terms of an all or nothing binary win or lose decision.
What we’ve really seen more than anything are historic levels of fear from individual investors.The questions we should really be asking ourselves are:
- Do I have capital that I can afford to risk and, if so, how much?
- How long can I leave it at risk and how much risk can I stomach?
- Are the odds good that I will earn a sufficient reward for the risk I can take?
If you’ve got some capital that you can risk today and you can leave it in the market for at least two years, I do believe that now is a good time to start putting capital to work by taking smart risks that will earn you a sufficient reward to compensate you for the risks you’re prepared to take.
First I’ll tell you why I believe that, and then I’ll tell you how I would go about doing it myself.
Investor fear
In terms of where we are at in the overall market today, we’ve certainly seen some serious corrections, as illustrated by a few of the assets highlighted above.
What we’ve really seen more than anything, however, are historic levels of fear from individual investors.
The American Association of Individual Investors surveys individual investors each week as to whether they are bullish, bearish or neutral on the stock market in the short term.
A recent survey put the percentage of individual investors who are bullish at just 15.8 per cent.
To find a lower reading than this, we have to go all the way back to 1992. Individual investors are less bullish today than they were during the Covid crash (23.3 per cent), the 2008 financial crisis (24 per cent), and the dot-com bust (26.7 per cent).
Warren Buffett famously said that to be successful an investor must be “fearful when others are greedy, and greedy when others are fearful”.
Investor fear hasn’t been this high for more than 30 years now. We’re definitely closer to a bottom than we are to a top.
Moreover, we’re seeing these unprecedented levels of fear in a relatively strong economy. Earnings per share for S&P 500 companies reached an all-time high for 2021 of $204.05 (£163.86). That was nearly double the level for 2020.
Be mentally prepared for any new capital you put to work to fall another 50 per cent as far as it has fallen already.That being said, it is worrisome that so many people are still asking 'should I buy the dip now?'.
It tells me that there is still more room for a downside swoon that could potentially leave a whole generation of investors to swear off the markets entirely for a decade or more.
Frankly, I really hope that we don’t get there because it would be an absolute tragedy to see so many young people lose a decade of opportunity.
Now that you know how I see it, here’s how I would play it. Be mentally prepared for any new capital you put to work to fall another 50 per cent as far as it has fallen already.
The S&P 500 has fallen 20 per cent already. You should be mentally prepared for it to fall another 10 per cent again. The Nasdaq has fallen 30 per cent already so you should be mentally prepared for it to fall another 15 per cent.
Take the capital that you’ve got available to invest for two years or more and divide it up into five equal parts. Invest 1/5th of your investable capital once a month for the next 5 months.
I believe that following this strategy you can reasonably expect to earn rewards that are double or triple the risks you take.
If you invest in the S&P 500, for example, and expect to risk 10 per cent, then it's reasonable to expect that you could earn a 20 per cent to 30 per cent reward in the next two years.
Richard Smith is a Berkeley mathematician with a PhD in System Science. He is founder and chief executive of risk analytics platform RiskSmith.
