Stocks are dropping: 3 rules for buying on the dip

How to play the stock market downturn.

The US stock market has fallen and keeps dropping, with the Dow, Nasdaq and S&P 500 now entering correction territory. The market considers a "correction" to happen when it drops 10% or more from its most recent high.

The Dow slumped in morning trade Monday US time to 33,274 and was down about 10% from its high on January 5. Extending a run of losses Tuesday, the tech-focused Nasdaq Composite is down more than 16% from its November high, closing in on the 20% decline marker that defines a bear market. The S&P 500 slumped 10% from its high on January 3.

What's happening?

Investors have been growing increasingly worried over a more hawkish Federal Reserve, which holds a policy meeting this week, as the central bank is likely to signal impending interest rate hikes to cool rising inflation.

It isn't just inflation weighing on investors, but also the rising case numbers driven by the highly transmissible Omicron COVID variant. While President Joe Biden has said he won't impose any new shutdowns or lockdowns to combat the new variant, Omicron could worsen inflation and the supply chain issues dogging the economy.

Retailers have already seen waning retail sales and understaffed stores and distribution centers because of staffing shortages, as rising COVID-19 cases keep employees home sick.

But for the most part, companies aren't falling on fundamentals, a key factor when looking for bargain buys. And good companies are still that, which suggests some bargain stocks are out there.

3 rules for buying on the dip

When stocks tumble, emotions and fear can lead investors to panic sell rather than evaluating the fundamentals.

Nobody can predict the future, but historically, markets have always bounced back over time. In the end, investors who endure market declines and stay invested, tend to come out in better shape. But stocks can also fall farther in the meantime, and not all stocks bounce back at the same pace. Some won't come back at all.

One way you can potentially come out ahead before the market bounces back is "buying the dip," a strategy where you buy a stock after its price has declined from a recent high. If the fundamentals are intact and the stock is oversold, you could be getting a bargain. If it rebounds, you'll make money.

Here are three rules for buying on the dip.

1. Don't try to time the market

Because more often than not, you can't. Timing the market is incredibly difficult, and investors who engage in market timing frequently miss some of the best days of the market.

According to J.P. Morgan Asset Management's 2021 guide to retirement, missing the 10 best days in the S&P 500 between January 2, 2001 and December 31, 2020, would have slashed your overall return by more than half. If fully invested, a US$10,000 investment would have topped US$42,000. Missing those 10 key days drops it to US$19,300.

Buying on the way down, even if not exactly at the bottom, allows you to get in when prices are low and accumulate shares with a lower cost basis — the amount you paid to purchase the stock. Your cost basis is used to calculate capital gains or losses come tax season.

2. Follow the fundamentals

Unless you're dealing with meme stocks or are a short-term trader, fundamentals matter over the long term. This is why you're hearing about the pros shifting away from higher risk stocks right now.

Though market sentiment can diverge from the fundamentals sometimes, essential factors like a company's earnings and profitability are a primary determinant of stock prices over time. So when a stock's price sinks because the market is falling, you can be confident it will eventually rebound if the company's underlying business remains sound.

For instance, some blue-chip companies that had otherwise been stable for years that were hit hard by the onset of the COVID pandemic represented an opportunity to buy into large corporations at their lowest prices in years. Investors who bought in before the companies' valuations recovered were in a position to ride the rebound back up. This recent downturn could present a similar opportunity.

Some stocks are cheap for a reason, though. Don't buy or hold a stock just because it's down.

3. Don't fixate only on buying the dip

If you're focusing solely on stocks trading at a discount because of a downturn, you could miss out on significant upturns in the stock market. In other words, you could miss out on substantial returns from stocks that are bucking the downward trend.

While the broader market is facing a downturn at the moment, energy stocks that drill for oil and gas have made double-digit gains so far this year. Oilfield service provider KLX Energy Services (KLXE) is up 60% year to date. BP Prudhoe Bay Royalty Trust (BPT), a US oil and natural gas royalty trust based in New York, is up 58% for the year.

So instead of focusing solely on buying up cheaper shares of falling high-growth tech stocks, you should also consider sectors that are performing well.

Now what?

A market downturn can be an anxiety-inducing event, as portfolio values drop and volatility rises. But worrying about a correction is the wrong way to invest. Pullbacks are to be expected, and investing is a long-term process.

Instead of selling, look for opportunities to buy valuable stocks at a discount. If their business is intact but their stock's price has fallen, it could signal a bargain.

At the time of publication, Matt Miczulski did not own shares of any equity mentioned in this story.