Is a pullback really a buying opportunity?

The Canadian, U.S. and international markets all fell more than 5% last week, the sharpest weekly drop we’ve seen in almost four years. Then today, on August 24, global markets plunged even further. If you were waiting for a pullback to give you a buying opportunity, you just got it. But if you’re sitting in cash and paralyzed with fear, you’ve just learned how you can get into trouble when you invest without a plan.

Let me be clear before we go further: I’m not recommending that investors hoard cash and wait for big drops like this one. Let’s remember that the last time we saw a sharper one-week decline was September 2011. The opportunity cost of being uninvested—even for a couple of months, let alone four years—can be enormous. So if your savings are coming from a regular paycheque, you are better off setting up an automatic investment plan that removes the emotion from your decision making.

However, If you recently came into a large lump sum—from an inheritance, the sale of a property or business, or a pension payout—things are a little different. You are still likely to be better off investing the lump sum immediately rather than spreading it out over a year or two: studies have consistently shown that the all-in move delivers better results about two-thirds of the time. But investing a huge chunk of cash is stressful, so it’s perfectly reasonable to accept a lower expected return in exchange for avoiding enormous regret.
But here’s the thing: dollar-cost averaging—or investing the lump sum gradually— sounds much easier than investing a lump sum. However, when it comes time to actually make each of those trades, you are still going to feel anxious. Indeed, dragging out the process over a year or more may actually be harder—like wading slowly into a cold lake instead of just taking the plunge.

One tough decision becomes many

I just heard from an investor who planned to invest his cash in two tranches: he put the first half into the markets in early July and planned to invest the second half later in the summer. But as prices continue to drop, he’s changed his mind. That money is still sitting in cash as he waits for “the right time.”

Let’s think about this decision for a moment. Prices are now much lower they were when he invested half his cash in July, so his plan to buy in two stages should have worked perfectly. And yet he couldn’t pull the trigger. And what if prices were now 5% to 10% higher than they were in July? Would he have felt better investing that cash when everything was much more expensive?

This is a perfect example of why dollar-cost averaging with a lump sum is fraught with danger. Investors think it will give them an opportunity to take advantage of dips in the market. But when those opportunities present themselves, they can’t bring themselves to buy. Without any plan, they base their decisions on their emotions and their futile guesses about where the markets might be headed. In this case, our investor is likely to remain in cash for a long time, since both rising and falling markets make him nervous, which is an impossible situation. And the longer he sits, the harder it will be to take action.

The lesson here is not that dollar-cost averaging is a bad idea. The point is that if you plan to ease into the market, you need to set a rigid schedule based on the calendar, not on market conditions. You might, for example, invest your cash at three-month intervals over a full year. (Rick Ferri offers some helpful advice about deciding when and how to use dollar-cost averaging in different situations.) Then you need to actually carry out your plan without second-guessing yourself, and that’s harder than it sounds.

This is one place where a disciplined advisor can be of enormous help, especially one with discretionary management. A disciplined plan is so important because it gives you a reason to invest. Your emotions, on the other hand, will always give you reasons not to.

This article originally appeared at Canadian Couch Potato.