TURN ON THE RADIO and, it seems, you can’t help but hear the holiday classic It’s the Most Wonderful Time of the Year. My question: From an investor’s perspective, is this indeed the most wonderful time of the year?
Apparently, it is. According to a 2017 paper titled Holidays Financial Anomalies, three of the best days for the stock market are the days after Thanksgiving, Christmas and New Year’s. And Dec. 30? Statistically, that’s the single best day of the year for stocks.
But where does this leave us? Yes, this “holiday effect” is clearly supported by the data, but what can we do with it? Does it represent some secret road to riches? To answer this question, it’s useful to look at the holiday effect in context. This is an example of what academics call an “anomaly”—a way to beat the market that persists and yet often we don’t fully understand why.
It isn’t the only one. Research has found dozens of them. There’s the value effect—that cheap stocks tend to outperform expensive ones. There’s the size effect—that small company stocks tend to outperform large ones. There’s the momentum effect—that a stock’s performance tends to carry over from day to day. Collectively, these effects are known as investment “factors.”
Is it worthwhile incorporating factors into your investment strategy? In general, yes, but here are five things to keep in mind:
1. Diversify your factor bets. Every factor has its season and will shine at certain times or in certain environments—but there’s no factor that outperforms all of the time. For that reason, if you’re incorporating factors into your portfolio, keep each one to a modest size. In addition, you might want to incorporate more than one. In the portfolios that I build, for instance, I include allocations to both small-company and value stocks.
2. Choose factors that are practical to implement. While the holiday effect is interesting, you’d have a hard time implementing it. The outperformance on the market’s best days is just fractions of a percent. It’s hardly enough to support an investment strategy, especially after figuring in trading costs. You’d have to buy stocks before each of those days, hold them for just one day and then sell them.
My advice: If you want to incorporate factors into your portfolio, look beyond idiosyncrasies like the holiday effect and instead choose factors that can be implemented more easily. A value stock strategy, for example, typically buys stocks and holds them for at least a year before selling.
3. Keep your eye on fees and taxes. One of the downsides of factor investing is that it takes some work, which means that factor funds are more expensive than simple index funds. At Vanguard, for example, its factor funds are at least four times more expensive than its basic S&P 500 fund. Also, factor funds buy and sell stocks much more frequently, which could leave you with a bigger tax bill. Bottom line: If you want to incorporate factors into your portfolio, be sure you don’t pay so much that it offsets any potential benefit.
4. Beware of shiny objects. A few years back, famed fund manager Bill Miller announced a new fund called Seismic Value Partners. His goal: to apply earthquake prediction techniques to stock-picking. It sounded odd, and I don’t believe the fund made much headway, but Wall Street continues to cook up new things like this. Last month, for instance, a Morningstar researcher highlighted a new fund that would incorporate a “New Age alpha proprietary human factor score” into its investment algorithm.
My recommendation: Before investing in any factor, you want to see two things. First, look for a long-term track record. Second, and just as important, the strategy needs to make logical sense. The small-company stock effect, for example, is easy to understand: Small companies are able to grow more quickly, on a percentage basis, than larger firms, so it makes sense that these stocks might perform better.
5. Remain vigilant. Investment historian Jamie Catherwood tells the story of an early factor investor, a Japanese trader named Yomiji Sumiya. In the 18th century, Yomiji devised an elaborate system of messengers, telescopes and hand signals to transmit prices between rice exchanges more quickly than others. Yomiji made a fortune, until the day one of his messengers got distracted by a friend. After stopping for several glasses of sake, the messenger mixed up his signals.
The lesson: Factors may have a limited shelf life, so be vigilant. In most cases, I recommend a buy-and-hold approach to investing. But when it comes to factors, you need to be more willing to make changes. At the same time, keep in mind point No. 1: Factors can, and do, underperform for extended periods, so don’t jump ship at the first sign of lagging returns. Instead, only abandon a strategy when the logic underlying a factor has fundamentally changed.
Adam M. Grossman’s previous articles include Imagining the Worst, The Unwanted Payday and No Comparison. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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