When Stocks Dip, It May Be Better To Hold Onto Your Chips

Whenever stocks hit a rough patch following a lengthy run-up, as they did at the beginning of the year, you begin to hear how the smart money is "buying on the dips." As in: "Buy These 20 Stocks on the Market's Dip" (J.P. Morgan) or "Correction Fears are Overblown: Buy the Dip" (the investing blog Seeking Alpha).

While a market rebound may seem like a victory for this approach -- and for bargain hunters in general -- don't kid yourself.

"What's insidious about 'buying on the dips' is that it sounds like a value approach," says Scott Clemons, chief investment strategist for Brown Brothers Harriman.

In reality, he argues, you're speculating based on the belief that the market's slightly longer-term upward momentum will continue to play out.

At least you're buying at lower prices. What's the harm? Plenty:

Fixating on recent -- and high -- prices

Our brains are hardwired to take certain mental shortcuts, which can lead to faulty analysis. For instance, investors tend to "anchor," meaning they use the recent past to base their expectations on where stock prices are headed.

"If a stock was at $80 a share and is now at $70, it's human nature to think there's $10 of upside because $80 was the rightful price," Clemons says. Yet the stock may never have deserved to trade that high.

Likewise, after a five-year bull in which equities consistently rebounded from every market pullback, you're likely to presume that stocks will continue to bounce back after every slide. The bear markets of 2000-02 and 2007-09 say otherwise, emphatically.

Road to wealth: Building your nest egg

Finally, this rearview bias is made much worse today by the fact that "people are anchoring on the S&P 500 when it was at all-time highs," Clemons notes.

What are stocks really worth?

Just because the S&P 500 falls 6% in price, as it did by early February, doesn't mean stocks are a buy. To make that determination, you must weigh what smart bargain hunters weigh: the actual value of stocks.

Valuations can be gauged using a number of factors, such as a company's revenues, assets, or profits. If you look at earnings, the January dip wasn't exactly a trip to Filene's Basement. The S&P 500's price/earnings ratio fell from an above-average 17.1 to a still-above-average 16.5, based on trailing 12-month profits.

Consider average profits over the past decade -- a conservative measure that has been a better predictor of future returns -- and the situation is much worse. The S&P's 10-year average P/E didn't budge in January and remains at a sky-high 25.2.

For stocks to deliver their long-term average inflation-adjusted return of 7% a year, history says the market's P/E would have to sink by more than 40%.

A weak record in the long run

There's nothing inherently wrong with trying to take advantage of market inefficiencies. But there are only a handful of good ways to do that -- and buying on price dips isn't one.

In 2011, Morningstar strategist Samuel Lee ran a basic experiment: Using data going back to 1926, he looked at how stocks performed in the prior three months. If they were down, he bought. (Remember that most of the time, the trajectory of the market is up and that's the momentum you're trying to exploit.) If returns were positive, he held cash until the next three-month price drop.

Lee determined that this strategy produced annual returns that were 2.3 percentage points below that of simply buying and holding stocks for the long run. Similar underperformance was found in other assets.

To beat the market, you have to exploit a true inefficiency, which is why hunting for stocks that are severely undervalued can work. So can momentum investing, if you use an approach that focuses on broad asset classes.

Yet even the pros often fail with these strategies. So Adam Nash, the CEO of Wealthfront, an online investment adviser, questions why you should bother trying. Certainly, he says, rather than waiting for dips to deploy more money, you're better off deciding on an appropriate long-term strategy and fully funding that approach from day one.