How to deal with buying the dips
All investors are prisoners of their past, and this shapes how they face the future.
Until the past few weeks, stocks have been like a perpetual money-making machine, rising smoothly for almost a decade and a half. From March 2009 to the January high, US stocks gained more than 800%. The pandemic panic of February and March 2020 only lasted five weeks.
It is therefore understandable that you think that the collapse of nearly 20% so far this year is just a blip. Stocks will soon resume their smooth upward trajectory, won’t they?
I hope so.
But, for all we know, the years ahead could look like 1966 to 1974 or 1929 to 1943, long slogs where stocks continued to shake up and down but essentially ended where they started.
In this case, you will need new weapons in your psychological arsenal. Consecutive years of low stock returns would plague anyone unprepared for a long stretch.
A weapon to consider is called average value. It’s like buying the dips – buying more shares as prices go down – on steroids.
At its heart, this technique combines two basic ideas: averaging (making money work automatically every month or quarter) and rebalancing (selling some of your winners and buying some of your losers).
In the average value, you set a target amount by which you want your account to grow each period. Suppose you want to end each month with $1,000 more than you started.
In times when stocks fall, you need to add enough to your holdings to meet the target you set for yourself.
If, for example, the value of your portfolio drops by $250, you would need to buy $1,250 of stocks to end the month with $1,000 more than you had at the start. If the value of your portfolio drops by $500, you will add $1,500, and so on.
In a rising market, you would buy less than $1,000 and even sell if stock prices exploded.
Average Value is the brainchild of Michael Edleson, former chief economist at the Nasdaq stock exchange and former director of risk for the University of Chicago’s endowment.
Most investors say they intend to buy and hold, but many end up buying high and selling low.
Investors who use average value “are committed to burying their demons”, says Edleson – “the demon of greed that makes you buy high and the demon of fear that makes you sell low”.
However, this technique cannot eliminate the risk of underperformance. “If you pick certain time periods, the average value can look awful,” Edleson says. “Your success will always depend on where you start and where you end.”
The strategy works best when volatility is high and worse when stocks are moving smoothly up or down. In a long, flat market, Edleson says, “there’s nothing better than buying and holding, just sitting on it.”
Buy low, buy low
In this simplified example of a market that is falling by a constant amount each month, different buying methods yield very different results.
in a sleeping bag
in a bull market
in a bear market
invested in a bull market
in a bear market
invested in a bull market
The average value is therefore a kind of bet that the markets will not return to the abnormally gentle upward slope of the mid-2010s, for example, anytime soon. If you think they will, this may not be for you.
Harald Deppeler, 53, a semi-retired physicist in Zurich, has been using the approach since 2013. He’s built his own spreadsheets to do it; most financial firms are not set up to automate customer value averaging.
The approach “makes you feel like you have a slight advantage, but it also tests you,” Deppeler says.
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While stocks rose smoothly between 2013 and 2018, his holdings in an S&P 500 fund exceeded his targets, so Deppeler had to sell about 8% to 12% of that position, he says. (Capital gains are not taxable in Switzerland; as a general rule, US investors should only consider averaging in tax-deferred retirement accounts.)
Mr Deppeler says he is aware that having to sell his holdings during a long bull market has likely cost him a small fortune in lost gains, although he has not calculated this opportunity cost. “I had a pile of money that I just couldn’t use,” he says.
On the other hand, in March 2020, the average value forced Mr. Deppeler to invest a “six-figure amount” in his S&P 500 stock fund during a terrifying decline. “It forced me to say, ‘The market is always down, and now I have to buy into it,'” he recalls.
“At the time, I kept thinking to myself, ‘That’s what the plan is for, to make you buy more when the market goes down. Stick to the plan, stick to the plan,” says Deppeler.
“If someone can really take the right amount, put it in stocks and let it go up, rebalancing every once in a while but holding it otherwise, I’m not going to tell them that the average value is better,” says Mr. Edleson. “But in practice, few people can do it.”
Again, if you don’t have the discipline to buy and hold, you may not have the extra discipline to buy even more in a bear market.
Few things are more difficult than buying more when markets fall. This is why discipline is an investment superpower. The average value might help some people stay on course, but it takes work and it won’t work all the time. Again, in the markets, nothing works all the time.
Write to Jason Zweig at [email protected]
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