Should You Wait for a Market Pullback?
With the U.S. equity market approaching its all-time high, it isn’t surprising that many advisors and clients are asking what’s next: invest at these levels or wait for a market pullback. As asset allocators, we have tactically lightened our equity exposure as the markets moved higher – securing gains and anticipating better opportunities for re-entry in the future. However, for most investors, waiting for a pullback might not be appropriate depending on their individual goals and circumstances. Investors should instead consider dollar cost averaging.
Buying on dips.
Do sell offs in the stock market offer a great buying opportunity? The investing axiom, long held by retail and professional investors, says that big declines in the stock market offer great investment opportunities to buy stocks at a discount. As the market drops, such as we saw in October and again in December last year, buying stocks can offer a potential opportunity for obtaining more upside as the markets bounce back.
The other benefit to buying the dips is in its improvement in investor behaviors. Without a defined investment strategy, most investors tend to buy stocks when conditions are good, and the market has moved higher – a combination that inspires the confidence to invest. When conditions turn sour and the market falls, investors tend to sell, concerned that conditions could worsen. This behavior generally results in poor returns. Buying the dips flips that bad behavior on its head.
Not without challenges.
Is a good buying opportunity the same thing as an investment strategy? Not really. Investment strategies require a more continual plan. A strategy, for example, requires a buy and a subsequent sell. A strategy must also consider the opportunity cost (missed upside) of waiting for a pullback.
Buying on dips optimistically assumes that the market will recover, but what if the dip ends up being a cliff? A 5% pullback could quickly turn into a 20% drawdown. Or worse, the market could slowly melt down, pulling back and failing to recover to a new high, only approaching the new high before drawing down again. When designing a strategy, these questions become important considerations and make the strategy more difficult for most investors to follow precisely overtime.
With that in mind how does buying on dips measure up?
The expected return following a pullback is mixed.
Drawdown has some impact on forward return expectations. The average S&P 500 price return after a big drawdown is very similar to the market’s long-term historical average of about 7% (figure 1). The distribution of future returns following a pullback has a very negative skew. Put simply, you may get stocks at a bargain, but like shopping during any sale, there is always a risk that an even better sale is right around the corner. Nonetheless, buying after 10% and 20% pullbacks have historically improved median expected returns.
|Drawdown||Sample Size||1-Year Return|
Probability distributions of 1-year forward returns
Sources: NYLI MAS, Bloomberg, 2/15/19. S&P 500 Price return beginning in 1950 following each of the drawdowns 5%, 10%, 15%, and 20%. Sample size includes the number of counts. 1-year return is the average price return of each occurrence. This should not be considered investment advice. Past performance is no guarantee of future results which will vary. An investment cannot be made in an index.
The catch: What you miss is bigger than what you gain.
Waiting for a market pullback before allocating capital can be extremely painful. First, the market has historically posted significant gains without a substantial pullback leaving the investor missing out on both price appreciation and dividends. Second, because of compounding, missing a big market move upward can significantly reduce returns (figure 2). Waiting in cash is inappropriate for most investors’ goals – particularly for investors looking to build long-term wealth.
Source: S&P 500® Index, 12/31/18. Average annual returns are based on the S&P 500 Index from 12/31/02-12/31/17. Large-capitalization stock performance is measured by the S&P 500 Index, an unmanaged index considered to be representative of the U.S. stock market. Prices of common stocks will fluctuate with market conditions and may involve loss of principal when sold. Results assume reinvestment of all distributions, including dividends, earnings, and expenses, and are not indicative of any past or future returns of any investment. It is not possible to invest directly into an index. Past performance is no guarantee of future results.
A true investment strategy.
In the long run, most investors are better off dollar cost averaging, a strategy that involves buying a fixed dollar amount of an investment, fund, or portfolio on a regular basis. The strategy does not guarantee a profit, but it has many benefits. Most important among these is that dollar cost averaging encourages good investment behaviors. By buying at set intervals, the strategy helps take the emotion out of timing investments. What’s more is that dollar cost averaging essentially reinforces the discipline of purchase volume based on price levels. In other words, a set dollar amount will purchase more shares when prices are low, and fewer when prices are high.
Source: New York Life Investments, 12/31/17/ this hypothetical example shows how dollar-cost averaging may work in a down market. It is for illustrative purposes only and does not reflect the actual performance of any investment product. Dollar-cost averaging does not guarantee a profit or protect against losses in a declining market. Investors should consider their ability to continue purchases through periods of low-price levels.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. Asset allocation and diversification cannot assure a profit or protect against loss in a declining market.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
The S&P 500 Index is widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
A drawdown is a peak-to-trough decline during a specific period for an investment, trading account, or fund.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.