Why waiting for a pullback can be a risky investment strategy

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Ryan Modesto, CFA, is CEO at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.

Everyone likes a sale and the feeling that they are getting a deal. Buying a new T.V. at half price on Boxing Day or Black Friday can really get the serotonin levels rising. So it is no wonder that this same habit translates over to investing. Almost everyone wants to buy stocks at a discount or on a pullback so they feel like they are getting a good deal. But unlike shopping for sales on a new T.V., waiting for a pullback in a stock could be one of the most expensive mistakes an investor can make.

Flawed logic?

Before we even get into why waiting for a pullback can be so costly, we should first look at why the logic of waiting for a pullback is flawed when investing:

If an investor does not deem an investment worthy at the current price, but after a 2-per-cent, 5-per-cent, or 10-per-cent pullback they are happy to buy, what happens if/when the stock rises back to that initial level that you were once unwilling to buy at? Do you immediately sell? Unlikely, but in theory if you were not willing to buy it at that price originally, you should be selling it once it gets to that price after already holding the security. This also means that you would be immediately capping the return potential. Buying on an X-per-cent pullback would imply that you are only expecting an X-per-cent return on the stock, and since in most cases in which investors consider buying a stock when it is cheaper they are talking single-digit pullbacks, the potential returns would be rather meager. That's not even accounting for fees and taxes – which leads to the next point.

Penny wise, pound foolish

Waiting for that 2-per-cent pullback on a stock is a great example of being penny-wise but pound-foolish. It is an attempt to save a bit money or get a better deal when in fact, over a three- or five-year period, for example, it will not even matter whether you got the shares at a discount or not. Even if we assume only a 5-per-cent annual gain for five years, $100 invested would grow to $127 – a 27-per-cent gain. If you were able to scoop those shares at $98, you would get a 30-per-cent return. Yes, it is still more than 27 per cent, but more than likely not a material factor in a buying decision when dealing with returns in the 30-per-cent area. Add in factors such as the shares going lower or higher the next day, missed dividends, and simply forgone time being in the market, and saving a couple percentage points in the context of a long-term investment appears even more tenuous. Here are a few more questions that need to be answered if you are waiting for a pullback in a stock of interest:

• What is the appropriate pullback amount? Why that amount?
• If shares are declining, do you have the stomach and patience to try to catch the falling knife?
• What if the pullback never comes? Will you just forego what could be an investment in a great company? (This has been a tough lesson for bearish investors since 2009)
• If the shares are declining, what if something is actually wrong and you are missing it?

Taking advantage of momentum

For fans of factor investing, one of the few factors that seem to continually generate alpha in the data over time is that of momentum. First published by Mark Carhart, momentum investing is essentially the idea of buying companies that are already seeing price strength (or shorting companies seeing weakness) as this price action tends to persist. Other ways of explaining momentum investing are that it is a strategy of owning what is working, or a strategy of buying high and selling higher. This is one of the few anomalies in the market that tends to throw a wrench into theories such as the efficient-market hypothesis, and it is one that is found globally. (Why this is the case is a discussion for another day.) Amid the limited edges that are out there, buying stocks on weakness (or on a pullback) goes against one of the more reliable edges an investor might have. This further bolsters the idea that waiting for weakness could lead to missed opportunities on a stock that may actually continue to see strength, and the idea that once the weakness appears, it very well may continue and exist for a wholly rational reason (i.e. something bad happening with the company). For readers looking for more detail around momentum, this link has more detailed data.

To be fair, this is not an argument against trying to get the best price possible. Of course one would always want to maximize their returns. But if an investor has already gone through the steps to determine that they want to invest in a company, why are a couple percentage points for an entry point the factor that is holding you back? If such a small amount is what is keeping you from entering a position, it could perhaps be a sign that the potential return on the investment simply isn't attractive enough to warrant buying it in the first place. Not to mention that if that small amount is the difference between a buy and sell decision, the investment is probably not leaving you with a whole lot of margin for error should things not progress exactly as you think (and things rarely do). There will always be a better price, but waiting for it can be costly.

In the next piece, we will take a look at real-life examples of when waiting for a pullback proved to be costly for investors. However, with all the talk of discounts and deals, we would be remiss if we did not offer a free trial to 5i Research with which you can gain access to model portfolios and research on stocks, courtesy of The Globe and Mail.

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