Buy On The Dip Or Follow The Trend?
Why so many people defend such opposite strategies on the market?
The expression “buy on the dip” refers to purchasing an asset after it has declined in price. The idea is to buy it cheaper, increasing the potential for financial return. On the other hand, the expression “follow the trend” refers to purchasing an asset after it has shown upwards movements in the price, based on the idea of whatever is pushing the price upwards, it will continue to do so. It seems like these strategies work in the opposite way, but it is easy to find market participants who claim gains from using both strategies.
Momentum & Bargain. The Market Paradox?
Looking at some stock charts one can easily see price moving on trends. This empirically observed tendency for rising asset prices to rise further is called momentum, and it helps analysts to estimate how likely an asset will rise or plunge in a given period.
The momentum is evaluated over a period many times longer than the period of price movement one wants to estimate. For example, a downtrend in a ten weeks interval can show a higher probability of a price decrease for one week ahead, but it says nothing about the price one year or one decade ahead. Therefore, momentum is used for insights and decisions in the short-term.
On the other hand, buying on the dip is a kind of strategy that is useful for long-term investors. In this sense, short-term trends don’t matter much since the market going up or down in the last weeks doesn’t tell much about the price in the long-term.
It is very difficult to make some kind of prediction on the price for decades ahead. Therefore, the long-term investor control what he can, the purchase price.
But you may still ask yourself. If an asset price going down tends to keep going down, why doesn't the long-term investor usually follow a downtrend and wait for a much lower price to buy an asset? Well, the attempt to be right in the short-term can have a high cost in the long-term since the moment the investor realizes that the asset has its trend inverted, the price might not be so attractive anymore. Due to this, a good moment for the long-term investor to open a position can be during a dip when the price looks cheap enough for him.
Note that, in order to follow the trend, a long period of data is taken into account for trend identification when compared with the period of forecast, which is very short. In the opposite way, dips on the market occur for a short time, while the investor keeps his position for a very long time.
So, Is It That Easy?
Unfortunately, it is not that simple as it seems. For the trend follower, the momentum effect doesn’t guarantee the continuation of the trend, in fact, the trend will revert at some point, and the most difficult thing on trading momentum is to know when to close an open position if the price trend reverses.
For the buyers on dips, as said before, during a market plunge, when the price looks cheap enough, it might be a good time to buy an asset. It is a perfect scenario if the investor is already going to buy an asset and this situation suddenly happens. However, a scenario where the investor keeps cash waiting for a dip might not be ideal, since it can take too long for this to happen. In long-term investment, time is as important as the price.
