« Is there a correction in the stock markets? How to calculate taxes from capital gains and combine them with your other income »

Markets are falling. Should you buy the dip?

Posted on 26 Jan 2022
Author: Sayan Sircar

7 mins read
📢Get new post notifications on WhatsApp!

This article talks about short-term changes to your investment strategy to take advantage of downward market movements. Does it work?

Markets are falling. Should you buy the dip?

Introduction

Whenever the stock market corrects slightly, many investors start wondering one of two things: if only they could exit earlier before the fall. Another common question is if there is a way to know when the market will recover to enter at the bottom with extra cash.

A related question is, once the market stops correcting, what happens if instead of monthly investment in SIP form, we wait for the market to fall, say by 2-10%, and then invest. The idea seems workable intuitively, given that markets go up and down and corrections happen frequently. After all, we have shown, using data for the Nifty 50 since 1993 that:

a 50% or worse fall is expected once every 10 years
a 40% to 50% fall is expected once every 5 years
a 30% to 40% fall is expected once every 2 years
a 20% to 30% fall is expected once every 11 months
a 10% to 20% fall is expected once every 6 months
a 5% to 10% fall is expected once every 4 months
a 2% to 5% fall is expected once every 2.5 months

Read more on this analysis here: Is there a correction in the stock markets?

So the natural question comes that we can use this to our advantage and invest opportunistically.

Corrections are available all the time

We will take a slight detour to show how the stock market offers corrections and hence opportunities at every scale, be it a day, a week, month, year, five years or even decades as shown below for the Nifty 50 for the day ending 24-Jan-2022. The three black line segments, superimposed on every chart, show the same fundamental repeating pattern of the market correction. However, we will examine what happens in the segment that leads up to the correction. That is where our tactical buying comes in.

Fractal view of the stock market

This concept, called the fractal view of markets, is explained in more detail in this book: The Misbehavior of Markets.

Did you know that we have a private Facebook group which you can join for free and ask your own questions? Please click the button below to join.

The buying strategy

We will explore a straightforward strategy: a normal, yearly 10% incrementing, SIP for five years vs opportunistic buying:

Keep a fund in cash that goes up by the SIP amount every month, like a savings account or liquid fund
Every time the Nifty 50 goes down by x% (x=2%,5%,10%), then we invest either the entire amount in the savings account or half the amount
We do not rebalance into cash at any time

An opportunistic buying strategy is an example of tactical asset allocation since the strategic asset allocation will be reached only during rebalancing. Investors wishing to know more about asset allocation, before progressing, should refer to this post: What should be the Asset Allocation for your goals?.

We use Nifty 50 Price index data from NSE since 1992 to compare. We have 8 cases:

Normal SIP of ₹1000/month that increases by 10% a year
Buy 100% of the cash buffer whenever the market falls 2%, accumulate cash otherwise
Buy 100% of the cash buffer whenever the market falls 5%, accumulate cash otherwise
Buy 100% of the cash buffer whenever the market falls 10%, accumulate cash otherwise
Normal SIP of ₹1000/month which increases by 10% a year, but only 50% is invested, and the rest is kept in cash
Buy 50% of the cash buffer whenever the market falls 2%, accumulate cash otherwise
Buy 50% of the cash buffer whenever the market falls 5%, accumulate cash otherwise
Buy 50% of the cash buffer whenever the market falls 10%, accumulate cash otherwise

The simulation is run for 300 windows of 60 months each starting in 1993.

Risk and returns

We show rolling risk and returns and averages, maximum and minimum return and risk for all 300 time periods.

Returns of Nifty 50 tactical buying

As we see in the case of the returns, the standard SIP handily beats all variations of the opportunistic cases for average, best and worst returns. This result is expected in a market like India that has mostly gone up in the last 30 years. Of course, the conclusion will differ if the market goes sideways for the long term or is bearish for extended periods.

As mentioned before, the segment that leads up to the correction is the key bit here and that is the reason this intuitively fine strategy fails to beat a normal SIP. If the market is overall going up, as with Nifty 50 from 1993 till date, it makes sense to be invested as early as possible. Even if a correction comes, that correction will come after the market reaches higher and higher peaks repeating the same fractal pattern. We have assumed zero returns from the cash component, but a 3% annual return on cash, for example, will not materially alter this conclusion.

Risk of Nifty 50 tactical buying

The risk charts show that the opportunistic buying strategy is marginally better risk-wise because they hold a fair bit of cash. This is the reason why the risk is lower as we are waiting for a more significant dip as the cash component of the portfolio increases.

However, the lower risk does not justify the lower return of the opportunistic buying strategy, given the extra effort in tracking the markets and then letting emotions affect the timing of the buy. It is incredibly human to freeze or think of exiting the market instead of going in when corrections happen. Simultaneously, if the model says to invest at 5%, it is tempting to wait for 10%. However, markets are unpredictable, and the bottom can come and go without taking any action. This is the implementation risk of the opportunistic buying strategy.

If we assume that overall, as an asset class, the equity markets will go up over time, the recommendation will be to invest as soon as cash is available. For most people, this will align with monthly salary income and hence they should invest in SIP mode.

A note on risk management

It is essential to understand that is investing strategy involves only the equity part of the portfolio. Investments into debt and other asset classes and subsequent rebalancing will happen in the usual way. Therefore, our recommendation still stands at having a suitable asset allocation and implementing corridor-based rebalancing as per predefined rules created before investment starts.

These are the tools that help manage the risk of the portfolio irrespective of where the market is going:

asset allocation ensures that the portfolio is not exposed to risk from the same source. This ensures that while some parts go down (like stocks), others like bonds or gold do not and vice versa
rebalancing allows you to systematically transfer the profit from one part of the portfolio that has gone up a bit into another part that has not
a glide-path manages the risk of the portfolio to ensure that as time passes and the goal comes closer, the total risk of the portfolio is reduced over time. This risk reduction leads to a lower impact of a market crash on the portfolio

Investors should understand that buying the dip is a losing strategy in a decades-long bull market and should not implement such opportunistic buying since that has implementation risks.

What's next? You can join the Arthgyaan WhatsApp community

You can stay updated on our latest content and learn about our webinars. Our community is fully private so that no one, other than the admin, can see your name or number. Also, we will not spam you.

To understand how this article can help you:

If you have a comment or question about this article

The following button will open a form with the link of this page populated for context:

If you liked this article, please leave us a rating

The following button will take you to Trustpilot:

Discover an article from the archives

Worked out case studies for goal-based investing

Case study: how can this middle-aged investor with two children plan for retirement and children's goals?

This article shows how a single-income middle-aged couple with two small children reach their retirement and children’s goals.
Case study: can this double income single kid family reach FIRE at 50?

This article shows how a double-income couple with a 2-year old reach their FIRE dream at the age of 50.
Case study: how a family in their mid-30s with a newborn kid can FIRE and invest in real estate?

This article shows how a double-income couple with a newborn child can invest for their future goals of FIRE and real-estate investment.
Case study: how this double income recently married family can perform DIY goal-based investment planning

This article shows how a young just-married couple can invest for future goals using the Arthgyaan goal-based investing tool.
Case Study: How should couples in their 40s with a new baby plan their financial future?

Did you welcome a bundle of joy in your 40s? This article will discuss ways of planning the child’s (and your’s financial future)
Case study: how this double income single kid family can perform DIY goal-based investment planning

This article shows how a very typical salaried couple with one child can invest for future goals using the Arthgyaan goal-based investing tool.

Previous and next articles:

<p>A stock market correction happens frequently. Here is how you anticipate and deal with one.</p>

Portfolio Review Market Movements

Is there a correction in the stock markets?

A stock market correction happens frequently. Here is how you anticipate and deal with one.

Published: 24 January 2022

7 MIN READ

<p>This article talks about understanding capital gains tax calculations and computing offsets vs other income.</p>

Tax

How to calculate taxes from capital gains and combine them with your other income

This article talks about understanding capital gains tax calculations and computing offsets vs other income.

Published: 28 January 2022

9 MIN READ

Latest articles:

<p>This article looks at the various stages of your career from the perspective of maximum wealth creation.</p>

Portfolio Construction

Which stage of your career is most important for wealth creation?

This article looks at the various stages of your career from the perspective of maximum wealth creation.

Published: 17 April 2024

4 MIN READ

<p>This article explains the new rules regarding income tax return verification which are now in place for tax returns to be filed 1st April 2024 onwards.</p>

News Tax

When should you verify your Income Tax return as per the new rules effective from 1st April 2024?

This article explains the new rules regarding income tax return verification which are now in place for tax returns to be filed 1st April 2024 onwards.

Published: 16 April 2024

2 MIN READ

Topics you will like:

Asset Allocation (21) Basics (8) Behaviour (12) Budgeting (12) Calculator (25) Case Study (6) Children (17) Choosing Investments (40) FAQ (12) FIRE (13) Gold (21) Health Insurance (5) House Purchase (28) Insurance (16) International Investing (12) Life Stages (2) Loans (17) Market Data (7) Market Movements (16) Mutual Funds (46) NPS (7) NRI (19) News (18) Pension (8) Portfolio Construction (52) Portfolio Review (27) Reader Questions (8) Real Estate (7) Research (5) Retirement (38) Review (15) Risk (6) Safe Withdrawal Rate (5) Set Goals (28) Step by step (15) Tax (59)

Next steps:

1. Email me with any questions.

2. Use our goal-based investing template to prepare a financial plan for yourself.

Don't forget to share this article on WhatsApp or Twitter or post this to Facebook.

Discuss this post with us via Facebook or get regular bite-sized updates on Twitter.