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…When prices drop, should investors buy the dip in anticipation of prices going back up or, when prices rise, should they buy the rise in case the climb continues or should they follow a financial plan? [In this article] we compare these scenarios…to see which one has delivered better returns.
A Tale of Three Portfolios
@$To evaluate these strategies, we compared the historical performance of three hypothetical portfolios:
- Buy the dip: 100% of the portfolio was invested in the worst-performing asset class from the prior year.
- Buy the rise: 100% of the portfolio was invested in the best-performing asset class from the prior year.
- Follow a plan: A balanced portfolio of 60% U.S. large cap stocks and 40% U.S. investment grade bonds for the entire duration.
We considered 13 asset classes to determine the best and worst-performing assets in each year.
| Equities | Fixed Income | Alternatives |
|---|---|---|
| U.S. Large Cap Stocks | U.S. Taxable Municipal Bonds | Gold |
| U.S. Small Cap Stocks | U.S. Investment Grade Bonds | Equity Real Estate Investment Trusts |
| Developed Market Stocks | U.S. High Yield Bonds | Hedge Funds |
| Emerging Market Stocks | Foreign Bonds | Global Commodities |
| Cash (U.S. Treasuries) |
Four were within the broad category of equities, five were under the fixed income umbrella, and four were alternative investments.
Portfolio Values Over Time
@$$We assumed all three portfolios had the same starting value of $10,000 as of January 1, 2011. Here’s how the year-end values of the portfolios would have changed over the last decade.
| Buy the Dip | Buy the Rise | Follow a Plan | |
|---|---|---|---|
| 2011 | $10,007 | $10,893 | $10,433 |
| 2012 | $11,890 | $12,076 | $11,541 |
| 2013 | $11,896 | $12,421 | $13,689 |
| 2014 | $11,911 | $13,137 | $15,109 |
| 2015 | $7,997 | $13,509 | $15,301 |
| 2016 | $8,906 | $14,674 | $16,488 |
| 2017 | $8,979 | $16,616 | $18,814 |
| 2018 | $9,142 | $14,368 | $18,386 |
| 2019 | $10,754 | $14,685 | $22,360 |
| 2020 | $10,812 | $17,387 | $25,414 |
- The buy the dip portfolio ended close to where it started, with total gains of just $812.
- The buy the dip portfolio saw gains of over $7,000.
- The balanced portfolio more than doubled its original value…
Risk and Return
Of course, return is only one side of the equation. To properly evaluate all three strategies, investors can consider both risk and return. Below, we look at how risk and return stacked up for each portfolio over the 10 year period. (Standard deviation based on annual returns.)
| Buy the Dip | Buy the Rise | Follow a Plan | |
|---|---|---|---|
| Cumulative Return | 8% | 74% | 154% |
| Min Annual Return | -33% | -14% | -2% |
| Median Annual Return | 1% | 7% | 11% |
| Max Annual Return | 19% | 18% | 22% |
| Standard Deviation | 14% | 9% | 7% |
- The buy the dip strategy had the lowest cumulative return and the highest risk. For instance, this portfolio experienced the biggest one-year decline of -33%, and had the highest standard deviation of 14%.
- The buy the rise portfolio’s worst drawdown was -14% and it had a standard deviation of 9%. Notably, its median annual return of 7% was much higher than that of the buy the dip portfolio.
- The follow a plan portfolio performed well on all fronts. Compared to the other two portfolios, it had the highest cumulative return and the lowest risk. Over the 10 year period, its worst annual performance was a decline of just -2%.
Buy the Dip: More Effort & More Risk
@$$$Notably, there are lots of variables that could affect the results of these strategies.
- Time period: Are there general market conditions at play? For example, U.S. large cap stocks had a bull market for most of the period we studied, boosting the return of the balanced portfolio.
- Types of securities: Is the portfolio investing in entire asset classes, or specific companies?
- Short-term or medium-term movements: Is the portfolio tracking daily dips and rises, or annual dips and rises?
Conclusion
Based on this set of data, buy the dip and buy the rise strategies have historically had lower returns and higher risk than a balanced portfolio. If the market doesn’t move in the way the investor predicts, this can result in large drops in the portfolio. It also requires more effort to track these trends, and could result in higher fees from more frequent trading.
In contrast, following a balanced portfolio has historically resulted in lower risk and higher returns. By sticking to a plan, investors are also much more likely to be aligned with where they are on the investor lifecycle. This means their investment choices match up with their goals and risk tolerance.
The above version of the original article by (visualcapitalist.com) was edited and revised for a fast and easy read.
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