Occasional price declines are a normal part of investing.
Many investors do not understand the mechanics behind stock market corrections and make suboptimal moves as a result.
By understanding the statistical nature of stock market declines and the optimal strategy around them, you can use declines to your benefit and ease your mind.
However, the often-touted strategy of waiting in cash for a pullback to buy tends to underperform.
Investors typically have a vague idea of what they're getting themselves into by buying stocks but don't quite understand the mechanics behind market corrections. The mainstream media isn't helping investors make good decisions because creating fear drives viewership. Investors' memories are short, and market pullbacks are normal.
Personal finance writers and financial advisors often push suboptimal strategies that feel good, like excessively large cash allocations and dollar-cost averaging. By understanding what is statistically likely to happen, you can know what to expect when the market dips and answer other portfolio strategy questions, like whether you statistically do better waiting for pullbacks in cash or investing money immediately.
The stock market doesn't go straight up.
On any given day, stocks have roughly a 53 percent chance of rising and a 47 percent chance of falling. Over any given 3-month period, stocks rise 68 percent of the time, dropping the other 32 percent of the time. Over a typical 12-month period, the odds of making money in stocks rise to roughly 75 percent. However, if you are in the market for a long enough period of time, there is a 100 percent chance that you will experience temporary price declines at times.
Source: Thomson Reuters
After bottoming in early 2009, stocks have rallied massively but have not gone straight up. Recent history shows seven declines of 9.8 percent or more in the S&P 500 (SPY) since the bear market bottom (the current downturn is +/- 6 percent as of the time of writing this). Staying the course each time was the right move. By knowing what to expect from the market, we can sleep easier and make better investment decisions. In fact, we can make an educated guess about how often market corrections will occur in the future based on past data.
How often are corrections likely to occur?
Guggenheim Funds did a research piece this August on every stock market decline from 1946 on. They found that pullbacks, or declines of 5 percent or greater, occur about 1.5 times per year. Market declines of 10 percent or greater (corrections) occur roughly 0.5 times per year. Lastly, market declines of 20 percent or greater (bear markets), occur on average about every seven years.
Source: Guggenheim Funds
A couple of things jump out when comparing the recent data to the historical data. The first thing to notice is that market declines of 10 percent or greater seem to be becoming more common than they were in the past. I attribute this to the rise of quantitative trading. Markets are reacting (or overreacting) to new information quicker than they have in the past. On the flip side, markets seem to be recovering faster from declines. It's not immediately clear whether the increase in the number of roughly 10 percent or greater declines is statistically significant. However, as an investor, market corrections have implications for you.
The most obvious move is to move money countercyclically when you can. Pullbacks of 5-10 percent have only taken a month to recover on average. When the market does pull back, avoid selling into it, if possible. If you live off of your investments, you can draw money from your bond allocation for your living expenses when pullbacks happen, as they do, roughly 1.5 times per year. This way, you aren't fighting the traffic of other panicky and overleveraged people selling stocks into the slightest downturn.
Statistically, you usually only have to wait a month to recover. Also, if you happen to get a liquidity boost like an annual bonus when the market is down, you typically won't have to wait very long to make money off the bounce-back to the upside. Surprisingly, however, the data does not back up waiting in cash for a pullback.
Should you wait for a pullback to buy stocks?
Talking heads on CNBC love to claim that they are "waiting for a pullback" to buy. After all, it seems like the most natural and prudent thing to do. While there is a time and place to wait for price declines (and/or interest rate declines) to buy assets, the strategy of waiting for pullbacks to buy stocks is grossly overused. In the same vein, financial advisors like to push the use of dollar-cost averaging as a way to reduce risk and increase return. However, neither of these methods has been shown to outperform simple buy-and-hold over time.
Vanguard did an amazing white paper on this phenomenon a few years ago, entitled "Dollar-Cost Averaging Just Means Taking Risk Later." I always like to link to sources, but I actively encourage everyone who has the time to read the white paper (it's only 8 pages). In the paper, Vanguard found that lump-sum investing – not waiting for a pullback, outperformed dollar-cost averaging/waiting to invest roughly two-thirds of the time. Here's what they had to say about waiting:
Clearly, if markets are trending upward, it’s logical to implement a strategic asset allocation as soon as possible because it should offer a higher long-run expected return than cash.
Stocks clearly go up over time, so even though they are likely to pull back, the odds are that they will be pulling back from a higher price than the price you paid. Additionally, being invested allows you to collect dividends and interest, which you can either reinvest or use for lifestyle purposes.
Many, many personal finance writers and financial advisors push waiting for pullbacks, but the data does not back their claims up. Dollar-cost averaging has a place, for example, if you contribute to a 401(k) with each paycheck you are dollar cost averaging. This is acceptable because you aren't letting the money pile up in cash while waiting for a decline to time the market.
Where dollar-cost averaging does not have a place is the practice of letting cash sit only to take the risk later. Unless you have a solid macroeconomic reason that markets are likely to decline, stocks are the place to be. Right now, I see the potential for higher interest rates to drag on GDP (especially around the residential real estate market) but see no cause for panic in the greater economy.
Over time, stock returns converge with company fundamentals and risk moderates relative to the original amount invested. The old adage "that time in the market beats timing the market" is backed by statistical research. However, market pullbacks are common, and understanding how they work helps guide our decisions to buy and sell stocks. Knowing what to do (and what not to do) when the market pulls back helps you achieve your goals and get to where you want to be.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.