The chart below illustrates an example of this. Let’s say we are experiencing a pullback that will bottom at -10%. The first 5% decline simply alerts the manager that the market is in a pullback. Then, the strategy only has between -5% to -10% of additional decline to react (sell) if the strategy is to “avoid” any of the pullback. If a manager successfully gets out of the market before the bottom, he then has less than 1-5% of the initial recovery to reinvest without incurring a loss.
Most pullbacks have lasted just a week or two, often merely a few days. We think it is unrealistic that any strategy would be able to correctly sell and buy in such narrow windows, and attempting to achieve this increases the likelihood of whipsaw. If you apply this scenario to a strategy that employs margin, leverage or shorting, it only exacerbates the situation and can make the reaction windows even smaller.
Defensive Tactical Strategies
Since pullbacks occur with frequency and consistency, tactical strategies that avoid reacting to pullbacks can have a distinct advantage. In fact, not reacting to common pullbacks in bull markets has proven to be the better course of action from a performance, turnover and expense standpoint since 1946. It is not the ordinary pullbacks that devastate a portfolio; it is the large losses, corrections or bears, that induce investors to sell in the capitulation stage of a bear market, and can hinder long term success.