The Power of Buying Pullbacks

Buying pullbacks is a time-tested way to boost returns.  From time to time, we’ve discussed the utility in buying pullbacks in the market.  Buying the dips—instead of panicking and selling—is essentially doing the opposite of how most investors conduct their affairs.  In the past, much of that discussion has involved identification of market pullbacks using various oversold indicators.  (See, for example, Lowest Average Cost Wins.)  In a recent article in Financial Planning, Craig Israelsen proposes another good method for buying pullbacks.

The gist of his method is as follows:

The basic rule for investment success is as old as the hills: Buy low, sell high. But actually doing it can be surprisingly difficult.

Selling a stock or fund that has been performing well is tough. The temptation to ride the rocket just a little longer is very strong. So let’s focus on the other element: Buy low.

I propose a disciplined investment approach that measures performance against an annual account value target. If the goal is not met, the account is supplemented with additional investment dollars to bring it up to the goal. (For this exercise, I capped supplemental investment at $5,000, in acknowledgement that investors don’t have endlessly deep pockets.)

Very simply, the clients will “buy low” in years when the account value is below the target. If, however, the target goal is met at year’s end, the clients get to do a fist pump and treat themselves to a fancy dinner or other reward.

One benefit of this suggested strategy is that it is based on a specific performance benchmark rather than on an arbitrary market index (such as the S&P 500) that may not reflect the attributes of the portfolio being used by the investor.

In the article, he benchmarks a diversified portfolio against an 8% target and shows how it would have performed over a 15-year contribution period.  In years when the portfolio return exceeds 8%, no additional contributions are made.  In years when the portfolio return falls short of 8%, new money is added.  As he points out:

It’s worth noting that the added value produced by this buy-low strategy did not rely on clever market timing in advance of a big run-up in the performance of the portfolio. It simply engages a dollar cost averaging protocol – but only on the downside, which is where the real value of dollar cost averaging resides.

Very smart!  (I added the bold.)  It’s a form of dollar-cost averaging, but only kicks in when you can buy “shares” of your portfolio below trend.  He used an 8% target for purposes of the article, but an investor could use any reasonable number.  In fact, there might be substantial value in using a higher number like 15%.  (You could also use a different time frame, like monthly, if that fit the client’s contribution schedule better.)  Obviously you wouldn’t expect a 15% portfolio return every year, but it would get clients in the habit of making contributions to their account in most years.  Great years like 2013 would result in the fancy dinner reward, while lousy market years would result in maximum contributions—hopefully near relative lows where they would do the most good.

This is an immensely practical method for getting clients to contribute toward some kind of goal return—and his 15-year test shows good results.  In six of the 15 years, portfolio results were below the yardstick and additional contributions were made totalling $13,802.  Making those additional investments added an extra $12,501 to what the balance would have been otherwise, resulting in a 7.7% boost in the portfolio total.  Looked at another way, over time you ended up with nearly a 100% return on the extra money added in poor years.

Of course, Israelsen points out that although his proposed method is extremely simple, client psychology may still make it challenging to implement.  Clients are naturally resistant to committing money to an underperforming market or during a period of time when there is significant uncertainty.  Still, this is one of the better proposals I have seen on how to motivate clients to save, to invest at reasonable times, and to focus on a return goal rather than on how they might be doing relative to “the market.”  You might consider adding this method to your repertoire.

Buy pullbacks and use the rollercoaster ride of the market to your advantage.

18 Responses to The Power of Buying Pullbacks

  1. Chris says:

    Isn’t this just a variation of the old dollar value averaging strategy?

    I want my account to increase in value by $1,000 every month. Deposit $1,000 the first month.

    At the beginning of the second month the account value has declined to $900. You then deposit $1,100, so the account value at the beginning of month two is now $2,000.

    At the beginning of the third month the account value has increased to $2,100. You then deposit only $900 this month to bring the account value to $3,000. And so on.

  2. Ankur says:

    A couple of observations:

    a) A successful implementation of this strategy requires one to set a goal which will roughly be the average rate of return of a diversified portfolio for the next 10-15 years (or whatever is the time horizon of the investor). If one chooses too low a goal he will never top-up and similarly for a too high goal, he will always be topping up.

    b) The out-performance of this strategy is also not very clear. Its already a multi-asset strategy so I am assuming all my investments in T-bills etc is also accounted for and any top-up that comes must come from some un-invested cash. If I have extra cash to top -up my account in down years that means I did not invest that cash as soon as I acquired it. So in essence, what is being suggested is that I hold some cash and wait for down years to invest in. Will it better than if I invested the cash right away? Probably not otherwise you should be doing this with your entire capital rather than just an un-invested portion of it.

    Did that make sense? (I am not a professional financial planner or investment advisor, so I could be quite wrong.)

    Thanks.

  3. […] What happens if you only dollar cost average in down markets?  (Systematic Relative Strength) […]

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