If you are Warren Buffett, it is probably a good idea to increase your holdings as the market prices get slashed by a sudden downturn in financial markets.
If you are not, you must think further.
The idea of buying the market as prices fall is the traditional dip-chasing approach. It makes perfect sense if you happen to buy a dip, and the prices rebound.
But often times, it is difficult to make sure that there is no further downside during a market rout. Prices will not fall indefinitely, but they could well plunge more than investors can afford.
Risk of jumping on the back of a false bull-run.
The risk you can take when purchasing a potential dip depends on two important things: your risk tolerance and the depth of your pocket.
You must keep in mind that the main risk you run while entering a trading position is the margin call which may force you to liquidate your positions too early — even though your decision happens to be the right one in the medium to long-term.
Too early means, even if you are right, it may take time for the market to come back to its senses and you may not have enough margin to survive a further dip and you risk being kicked out of the game too early.
Therefore, we can say that it is ‘less risky’ to take risks if you have enough financial margin to support relatively large temporary losses in the shorter run.
If this is not the case, waiting until you see the market defining a clearer direction could be a better strategy, even though you must let go the ambition of buying the dip and maximizing your profits.
Watch for volatility.
Although no one knows what the future holds, there are some market indicators that throw light on the underlying market sentiment.
The most obvious and easy-to-track sentiment indicator is volatility — which is also referred to as ‘risk’.
Here, a quick dive into volatility is necessary. Market volatility is the dispersion of an asset’s prices (or returns) from an average historical level. From a statistical perspective, it is the standard deviation of a time series of an asset’s market prices (or returns).
The higher the dispersion of the price, the higher the volatility. The higher the volatility, the less the predictability of an asset’s future price. The less the predictability, the higher the risk.
So, when the market volatility is high, the risk is high.
In principle, you don’t need to compute volatility. You can, if you want, but there are indicators that are always available on the market to give investors an idea on the levels of market volatility.
The most popular market volatility indicator is the VIX index, which is ‘a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPXSM) call and put options.’
‘On a global basis, it is one of the most recognized measures of volatility — widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.’
You can track the VIX index on popular public financial websites, such as CBOE and Bloomberg.
One important aspect of the VIX index is that it does not give a direct information on the market direction, but only on the size of daily price ranges.
But we know that the market volatility tends to shoot up in times of market sell-off. Therefore, a higher volatility is often coupled with a bear market.
At this point, it is very important to understand that volatility is bad, no matter if the market rises or falls. A 10% upside volatility is almost as bad as a 10% downside volatility.
Surprised? Don’t be. A bear market has high volatility, while a bull market is often characterized by smaller, but sustainable gains — hence a relatively lower volatility.
Therefore, the golden rule of thumb is, the higher the volatility, the higher the risk of sell-off, or a further sell-off.
If you are looking to buy the dip during distressed times, it is important to make sure that the market volatility eased to levels that are suitable for a sustainable positive recovery.
Otherwise, you may be jumping on the back of a false bull-run.
Timing is the key challenge.
Good news is, the stock markets have had one and only long-term direction thus far.
A quick glance to the historical data on leading indices gives an immediate insight.
The FTSE 100 index was multiplied by 6 since 1984, the DAX index by 10 since 1988, and the S&P500 by 30 since 1980.
All indices suffered important losses during financial crises, but at the end of the day, the prices just kept on climbing to higher levels as economies grew.
Bad news is, if you had invested in the 80s, the chances are you were kicked out of the market during at least one of the market crashes.
However, you now know that there is always light at the end of tunnel. The real challenge is the right timing to hop on a bull market.