Should I buy the dip? That question has split the investing world in half. There is one set that will tell you that you should never average down. Another set will point out that if you liked something at Rs. 100, you should love it at Rs. 75. So you should be doubling down when the price falls. Who is right?
The answer is, as always, it depends. Any decision in investing is a function of your process.
Whether you should be averaging down when the price falls or selling out, is at least partly decided when you make the initial investment. The decision depends on what your thesis was when you made the investment.
There is one scenario when it is impossible to figure out the answer. That’s when you’ve invested simply based on a tip from a friend, or worse, a TV channel.
In that case, you probably don’t know what the original thesis was, and whether something had changed. If you got the tip from a friend, you could call them. And hopefully, they’ll know enough to be able to tell you what to do, and why.
Otherwise, it was probably a mistake to buy in the first place. And it will probably be a mistake to hold on or double down. But you really have no way of making an informed decision – unless you dig in and do some research now.
If you do decide to do some research, watch out for the endowment effect.
What’s your thesis?
In the happier situation where you did your homework before investing, we have something to work with. As I see it, there are two broad reasons you can make a specific investment.
One reason is essentialy that the security in question is undervalued compared to current fundamentals.
You have not invested assuming there is an immediate catalyst for value to be unlocked.
You expect things to work out over a three to five-year period. In those cases, it might often make sense to buy more, subject to overall exposure and portfolio considerations.
More on this in a minute.
The other reason sometimes is that you think a specific catalyst should cause the price to go up. Like the launch of several new products. Or benefits coming from some regulatory changes.
You expect prices to move favorably in a relatively short time.
In those cases, a material drop in price might actually be a strong sign that your thesis was wrong. In that case, rather than buying, it might be time to accept a mistake and exit. But watch out, the market can often test investors like you, before bouncing back.
But adding to the position might still be a mistake.
Humility is Important
For conviction investors, it is easy to assume that when the price of one of your investments falls, it is simply because the market is stupid. That might be true, but it is dangerous to have this as your default assumption.
All seasoned investors will tell you that the market is not wrong very often. So when the price does drop, you must try and ascertain the reason.
Sometimes a stock will drop right after an earnings announcement. The earnings might even look good and you might wonder why the stock dropped. But perhaps the market expected better results. Sometimes things are even more subtle.
The market might not like that the EBITDA margin was lower than expected. Or that earnings came more from other income than regular operations.
There is more to earnings than the earnings per share.
Even so, the question you need to ask is – does this affect my thesis. If you are expecting your thesis to play out over a longer period, you should check if the result suggests something that might derail the long-term view.
While quarterly earnings may not matter as such, they can contain hints that your thesis is turning out to be wrong.
One way to mitigate the heart burn when you see your investment drop in value is premeditation. That is, instead of being reactive, you can be proactive.
Before you make your original investment, you can ask yourself what you would do if the price were to drop. Is this position a time-sensitive position or a long-term bet.
In either case, what could convince you that things are not working out? Can you think of some situations that can cause the price to drop, but which you know you shouldn’t worry about?
This is easy to say, but much harder to do in practice. In general, if you’re buying, odds are that you are already convinced you are right.
This is why it is important to make this part of your process. And it rightly belongs in the analysis step. This is a practice that can be applied to many things other than investing as well.
Meanwhile, I hope you never are in a position when you have to wonder if you should buy the dip!