When You Can Buy Stocks on the Dip

With turmoil in North Korea, continued instability over global oil prices and a political rift right here in the U.S., you can't discount a stock market pullback, which could stop an investor's portfolio growth in its tracks.

But rather than lean into headwinds, why not focus on temporary market declines and use them your advantage? Buying on a dip can be very beneficial to a portfolio in the long run, but only if it's done properly, market experts say.

"In our opinion, buying on the dip is always a great idea for investors who have room in their portfolio," says Jonathan Monjazi, chief executive officer of CEO Based Investing in San Diego. "But investors should make sure the price decline in a stock is due to short-term issues that will not affect earnings or earnings growth in the long term."

[See: 7 ETFs That Let You Invest With the 'Smart Money'.]

One example that comes to mind is Monjazi's recent purchases of Tesla (Nasdaq: TSLA) stock, which declined in price in late July, "yet we saw no change in the future sales of its much-hyped Model 3 sedan, nor was there any indication that they would not meet their production numbers," he says. "Rather, it seemed to us that rumor, fear, and perhaps some profit taking was pushing the price of the stock down."

To Monjazi, if a company continues creating products people love, maintains a competitive moat, has earnings growth that justifies its valuation (even if only in the long term) and continues to innovate with a fantastic CEO, then it's a winner. "We see no reason why buying on a dip doesn't make perfect sense for a client who has the proper portfolio allocation and cash available," he says.

When you buy on market pullbacks, do so with your eyes wide open, and fully rational -- and patient -- about what to expect.

"Just because some companies decline does not mean they will come back quickly," says Brent Wilsey, founder of Wilsey Asset Management in San Diego. "Prime examples of this idea occurred during the tech bust. Two companies that dipped and had difficulty recovering are Microsoft ( MSFT) and Intel ( INTC). In December 1999, Microsoft peaked at a price of near $60 per share. Had you bought on the dip and paid around $50 per share, it would have taken you more than 15 years to break even on that investment."

When buying on a decline, Wilsey says it's important to avoid companies that are trading at sky-high valuations as these are the companies that have a higher risk of not recovering. "Back during the late '90s and early 2000s, Intel and Microsoft could do no wrong and were carrying extremely high valuations," he says. "When the tech bust occurred the valuations contracted as investors realized these companies were extremely overvalued."

[See: 9 Ways to Spot Value Trap Stocks.]

It's also important to do your homework on the company and see how much you are paying for the sales, book value, cash flow, earnings, and growth of a company. "Don't get sucked into the hype and buy the Intels and Microsofts of today," Wilsey says.

Others say that there are specific traits an investor should possess before stepping into the choppy waters of a market decline. Darryl Franklin, a money manager with Oakwood Wealth Advisors, in Lisle, Illinois, says since October 2011 he has made 10,059 trades in client accounts, many on the dips, and has lost money just 117 times.

"There are some guideposts to follow, and investors should know that," Franklin says.

He says investors shouldn't consider buying on the dip unless they are disciplined, have a written trading plan, sufficient assets to sustain a loss and can watch trading patterns and momentum during market hours.

In Franklin's own trading plan, the criteria he uses to help determine whether to buy on the dips or not includes answering these key questions:

-- Is the target to buy, low intraday, while the overall market is up?

-- Does my target have a mid-term trend of being positive demonstrating an upward trend?

-- Has the short-term chart reached a low relative to the open and/or yesterday's close?

-- Does the target have strong fundamentals, i.e. cash flow and/or above average dividend yield?

-- When will the company announce quarterly earnings?

-- What is the overall macro outlook?

In the final analysis, buying on the dips is not a get-rich-quick strategy but requires an approach that begins with discipline, Franklin says.

"I liken it to the holiday film classic, "It's a Wonderful Life," he says. "I like the scene where George Bailey, played by James Stewart, tells his customers not to panic when the savings and loan was in trouble. Yet Old Man Potter was busy buying when everyone was selling. Potter was buying on the dips, and in like manner, I try to buy on the dips when everyone else is selling."

Not everyone believes buying into a dip is a good idea for everyday investors.

"It's nearly impossible for investors to anticipate small market declines, and it usually isn't worth their time to try," says David Twibell, president of Custom Portfolio Group in Englewood, Colorado. "If you have cash available during a correction, by all means, use it to buy stocks if that fits within your overall investment plan. But repositioning your portfolio in the hope of timing a brief market decline simply isn't productive for most investors."

[See: 7 ETFs You Have No Business Buying.]

That doesn't mean you should simply sit still.

"The real danger for most investors isn't a run-of-the-mill market correction, but a bear market," Twibell says. "That's where big losses usually occur. And at least historically, most bear markets coincide with economic recessions. Follow the underlying economic data, particularly the forward-looking data, and you'll have a fighting chance of avoiding the next really big market mess."

Brian O'Connell is a contributing financial writer for U.S. News & World Report. A former Wall Street bond trader and the author of two best-selling books; "The 401k Millionaire" and "CNBC's Creating Wealth", he has 20 years experience covering business news and trends, particularly in the financial, technology, political and career management sectors. His byline has appeared in dozens of top-tier national business publications, including CBS News, Bloomberg, Time, MSN Money, The Wall Street Journal, CNBC, TheStreet.com, Yahoo Finance, CBS Marketwatch, and many more. Visit his web site at: https://brianoco.contently.com/. Or, visit this Amazon.com link for a list/review of some of his book titles. Reach out to him on LinkedIn.