It’s extremely difficult to buy stocks when they are plunging. Investors are emotional, so buying as prices decline is psychologically tough to do. Statistics show quite clearly that investors tend to do the opposite. The highest percentage of stock mutual fund redemptions occur at or near the bottom of bear markets. Yet, time and time again, history has proven, the opposite behavior is the appropriate one.

In periods like the last 18 months, since the Dow Jones Industrials peaked at over 14,000 in October 2007, and nearly every asset class fell off a cliff, it’s been particularly difficult parting with beloved cash positions. Cash has been king and those who sat on a big stash have slept well and felt brilliant as others got clobbered in the roughest market in decades. But, those with a ton of cash now will no doubt miss a very large chunk of any market recovery….especially if they have no reinvestment plan.

Let’s say your portfolio is presently underweight stocks and you are sitting on a lot of cash equivalents (i.e. CDs, T-bills, money market assets). Your plan is not to stay in cash indefinitely (heck, it’s paying next to nothing) and your target stock allocation is 50 percent of your investible assets. Still, since you probably sold some stocks in the past year or so, and since your remaining stocks have lost value, your stock allocation may now total only 25 percent or less of your entire portfolio. Your plan is to bring your allocation up to 50 percent. But, how are you going to overcome your paralysis and actually make purchases?

Stair-step approach

There is only one cure for this ailment and that is to have a battle plan and stick to it. Your plan may entail an all-at-once approach (if the market drops to “x” you’re going all in), or you may prefer a more prudent, stair-step approach. The stair-step plan would make you invest part of your cash stash, perhaps one-third at a time, on weakness. For example, if the Dow Jones hits 8000 again you begin your allocation, perhaps investing one-third of your target allocation for stocks at that point, and you continue to allocate more on the way down. Your plan could be to become fully invested if the market drops to 7000, or whatever level you choose.

The particular trigger points you choose for various stocks, or the market averages as a whole, aren’t as important as simply having a disciplined plan. Why? Because it’s very hard to invest when the market is declining – you not only think you can buy stocks cheaper tomorrow, but you also wonder why in the world you even want to own them at all when they seem to be in freefall. Without a clear plan, you are likely to remain on the sidelines and do nothing…and perhaps miss some healthy gains when the market improves.

How to catch a falling knife

My preference for investing cash that is earmarked for stocks is to enter buy-limit orders in the market, through your brokerage or bank account, at various levels, and stay the course. This means that if stocks drop, you will automatically buy them at predetermined levels. When a buy-limit price is reached, the order will be executed at the limit price or better. This is also a useful strategy if you want to buy stocks, but don’t intend to be chained to your computer monitor for fear of missing an opportunity. Simply enter the limit orders in the market, good-until-canceled (whatever date you choose), and see if the market’s volatility can work in your favor by allowing you to pick up stocks at lower levels, automatically.

One obvious problem for putting cash to work with a buy-limit approach, is if the market simply moves higher from here…basically straight up. This is possible, but unlikely in my opinion. Still, if you are anxious to put money to work, and you are presently underweight equities in your portfolio, you could certainly consider investing one-third (or whatever percentage you choose) of your target stock allocation right now and put limit orders in the market for the remainder. You can be creative and tweak your strategy to meet your personal objectives and stay within your risk tolerance boundaries.

Tough decade ahead

Jeremy Grantham, the well-known institutional fund manager, who oversees more than $78 billion for GMO, LLC, wrote in his Q1 2009 newsletter, that he sees a “50/50 chance of crossing 600 on the S&P 500.” That’s a long way down from present levels, but those are pretty high odds that stocks could move a lot lower again. More recently, given the market’s strong move off the March lows, Grantham sees about a one in three chance of the market heading back to the old lows. Regardless, he sees a difficult market ahead in the next decade. He thinks the recent run could push the S&P above 1000 or 1100 and then give us crummy returns for many years, trading within a frustrating tight range and unable to move to new highs for a decade or longer. Still, Grantham believes that if you’re able to invest on weakness (below fair value, which he pegs at 880 on the S&P 500), you are more than likely going to earn attractive average annual returns over the coming years.

For what it’s worth, I believe stocks are fairly valued close to present levels. The S&P 500 in the 900 to 950 range would indicate average returns going out over the decade, perhaps 6% to 7% averaged annually, given forward earnings projections and historical valuations. The further stocks drop over the short term, for whatever reasons, and assuming an eventual rebound in earnings (although I highly doubt to the peak levels seen in 2007), would make future returns that much more attractive – obviously if you buy at even lower levels.

Despite the recent rally in stocks, the market is still down nearly 40% from the highs recorded in 2007. If you have cash that is earmarked for stocks, but you’re having trouble finding the courage to buy, consider using buy-limit orders and a stair-step approach to investing. It’s a good way to keep the process disciplined and unemotional.