Buying the Dip? How to Find Dropping Stocks Before They Rally

When the U.S. stock market takes a nosedive, it doesn’t have to mean doom and gloom for long-term investors. Rather than selling off, this is a time to remain steadfast in your investments, and the dip itself may even signal an opportunity to buy in at bargain prices.

What does it mean to 'buy the dip'?

Buying the dip follows the basic investment principle of “buy low, sell high,” but with a slightly more targeted approach. There are two requisites for buying the dip: a sharp decline in stock prices, and a strong indication that they’ll rise again. One of the more common examples of this is when a large corporation’s stock price drops suddenly due to broad market fears, rather than concerns about the company’s long-term performance.

Just one example: Prior to the COVID-19 market crash, Johnson & Johnson’s stock price hit what was then an all-time high on Feb. 5. By March 23, it was down almost 28% — but as of April 20, 2020, the company had virtually erased all losses. Investors who bought Johnson & Johnson stock in late March bought the dip.

To be clear, no one knows when the bottom hits, and trying to time the market is never a good idea. But there are plenty of opportunities to invest in stocks during down periods if you’re ready to invest for the long term — and you know where to look.

How to buy the dip

Look at sectors hit hardest during the sell-off

Broad market index funds, which track a diverse stock market index such as the S&P 500, are a proven way to invest. But this same strategy can be applied to the 11 sectors that make up an index like the S&P 500, too.

Taking a look at sectors with the largest share price declines, then analyzing the mutual funds or exchange-traded funds that track that sector, could shed light on a few opportunities to buy the dip.

Below are the four stock market sectors that saw the largest year-to-date declines during the COVID-19 crash (as of April 20, 2020).

1. Energy. The S&P 500 energy sector was down nearly 45%, marking the most precipitous drop. Within that sector, the energy equipment and services industry showed the biggest losses, down 61%.

2. Financials. The financial sector also saw a severe drop, falling over 28%. This was driven by major declines in banks and consumer finance, which are down 39% and 43%, respectively.

3. Industrials. The industrial sector comprises industries like aerospace and defense, airlines, construction and engineering and electrical equipment. Driven by severe declines in the airlines industry (which is down nearly 57%), the entire sector is down 24% overall.

4. Materials. The materials sector, which includes industries like metals and mining, containers and packaging and chemicals, is down 20%.

» Find the funds: Open a brokerage account to invest in index funds that track these sectors.

Look at large companies with big drops

Like Johnson & Johnson, some of the country’s largest companies have been able to quickly recover from the coronavirus downturn. In fact, Microsoft and Amazon’s stock prices are both up year-to-date — for these companies, the dip is over, at least for now.

However, some blue-chip companies that have otherwise been stable for years were hit hard by the global pandemic, and their valuations have yet to recover. Looking for dips like those can provide an opportunity to buy into large corporations at their lowest prices in years.

» Access stock research: Read our review of Morningstar

This strategy comes with a warning, though: NerdWallet doesn’t recommend investing in individual stocks — experts typically think low-cost index funds are the best choice for most investors. Index funds are less risky than individual stocks, and add diversification to your portfolio through a single investment.

Max out your 401(k)

Investors may be encouraged to max out their 401(k) contributions during market dips, provided they have steady jobs and substantial emergency funds to tide them over should they need them. By upping your contribution, you’re essentially buying additional shares of investments you already own at a lower price.

But even maintaining the amount you’d been contributing before the dip would net you more shares per contribution, thanks to the lower share prices. Unless you need the additional monthly cash flow, the last thing you’d want to do is cease contributions during a down period.

Use dollar-cost averaging

If you have an IRA or other investment account, consider making steady investments at regular intervals, rather than a lump-sum contribution timed when you think is best. Through this strategy, known as dollar-cost averaging, you’ll continue to purchase shares throughout the dip.

401(k)s illustrate dollar-cost averaging in action: A percentage of every paycheck gets invested at regular intervals over the long term. Dollar-cost averaging can be used in all investment accounts.

No matter what strategy you choose, understand that buying the dip does not guarantee getting in at rock-bottom prices. In volatile markets, today’s floor could be tomorrow’s high. All it means is that company valuations are substantially lower than they were just a few months or weeks ago, offering investors an opportunity to buy at that relative low price.

If you believe share prices will eventually rise to or beyond previous highs, buying at today’s lower prices could be a good strategy for generating long-term returns — you may just have to stomach a few big drops before you realize them.

» Need a brokerage? View our full list of the best brokers.

Disclosure: The author held no positions in the aforementioned securities at the original time of publication.