The reason is simple. Markets tend to overreact to disappointing earnings, punishing the stocks. That means normally solid companies will bounce back quickly.
One wrinkle to consider in all of this is the so-called “wash sale rule.”
If you sell shares at a loss and then decide to buy them back within 30 days, you cannot take the loss on your taxes. A sale at a reduced profit obviously does not apply here, only those where the price realized at liquidation is lower than the price at which the shares were purchased.
But let’s say that you do end up selling at a loss. Does that mean dollar-cost averaging before the 30-day wash sale period is up will always result in a disadvantage?
The rule is there to prevent investors from attempting to churn through a down market move with repetitive buys and sells. Depending on the situation, it may still be to your advantage to buy back in, even if that means foregoing a tax loss.
If the stock is likely to bounce back in the short term, well within the 30-day period, the resulting price at the end of the period may still be a bigger cost than the tax loss afforded by the rule. In other words, there are companies that tend to perform strong enough to make dollar-cost averaging a good move even without a tax benefit.
Remember, the objective of dollar-cost averaging is to lower your actual cost per share. So each resulting advance in the share price will hand you a greater return than you would have gained by sitting on the sidelines.
It isn’t free money, but it’s the next best thing.
What to Watch Out For
The biggest decision involves when to make your move. Just know that companies with good fundamentals will respond faster than the sector as a whole. That means, on average, a quality company that declines by double digits in a week will usually rebound over a similar time frame.