Looking for an Edge

Adam M. Grossman

EVERY YEAR, WHEN spring rolls around, investment folks trot out a favorite catchphrase: “Sell in May and go away.” This is based on the idea that the stock market lags during the summer, as people go on vacation.

While it may sound hokey as an investment rule, it’s hardly the only one. There’s also the January effect, which says that stocks do better just after the new year. Its cousin, the January barometer, stipulates that the market will have a good year if it has a good January. There’s also an October effect, a Friday effect, a Monday effect and many more. My personal favorite is the Dogs of the Dow strategy, which involves buying the highest dividend-paying stocks in the Dow Jones Industrial Average. Collectively, these are known as stock market anomalies.

Belief in these anomalies is nothing new. In fact, in one of his novels, Mark Twain poked fun at the notion, with one of his characters saying, “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

What should you make of stock market anomalies? Was Twain right to dismiss them as silly folk tales or do they have validity? It turns out that they all have some kernel of truth. For instance, on average, markets have historically performed better in the winter than in the summer, supporting the dictum to sell in May.

Renowned hedge-fund manager Renaissance Technologies has reportedly profited from these strategies for decades. In The Man Who Solved the Market, which chronicles the firm’s history, author Gregory Zuckerman writes, “[The researchers] discovered certain recurring trading sequences based on the day of the week. Monday’s price action often followed Friday’s, for example, while Tuesday saw reversions to earlier trends.” Thanks in part to these strategies, Renaissance has achieved the best track record in the industry. These anomalies clearly shouldn’t be dismissed out of hand.

Still, you need to be careful. Before you base any investment decision on an old adage, keep in mind the following:

Coincidence. Anyone with statistical skills can perform what’s known as data mining, which is to sift through historical data looking for relationships. Invariably, if you look for long enough, you’ll find correlations. But as any statistics teacher will tell you, correlation doesn’t always mean there’s causation.

You might find something that looks like a profitable trading strategy, except it’s just a coincidence. A famous example is the relationship between sunspot activity and stock market gains. Yes, there’s data to back this up, but does that really mean that sunspots somehow cause the market to go up?

As recently as last week, I came across an article showing that the most profitable stocks to own over the summer are those of utilities and technology companies. In this case, and in others, I don’t doubt that the data is there. But if it makes no sense, it’s likely just a coincidence and not a viable strategy.

Friction. Another issue with any strategy like this is what economists call “friction.” If you really want to start buying on Fridays and selling on Mondays, you’ll be incurring significant trading costs. Even if your broker no longer charges trading commissions, there’s the bid-ask spread. On top of that, of course, there are taxes. And all this assumes you have the time and patience to devote to trading.

Probability. With all these strategies, there is the caveat that they work only on average. There’s no guarantee that they’ll work every time. In fact, a Renaissance employee once noted that the firm’s trades are profitable just 50.75% of the time.

This year provides a perfect case in point. Since May 1, when the maxim says you’re supposed to sell, the S&P 500 has gained 13%. The upshot: If you want to pursue strategies like those described above, it isn’t easy. You need to roll the dice a lot of times and put a lot of money behind it.

Persistence. In economics, there’s the “five-dollar bill theorem.” The idea is that you’ll rarely find money just lying on the ground. That’s because someone else will have already picked it up. It’s the same with investment markets. Whenever a trading strategy starts to work, others take notice and jump on board, and that tends to make the profit opportunity disappear. At Renaissance, in fact, employees are reportedly always changing the firm’s models because of this. The upshot: Even if a strategy worked in the past, there’s no guarantee that’ll continue.

What should you do? As always, my advice is to keep things simple. In my opinion, the best investment for most people, most of the time, is a simple total market index fund.

But I’m not an absolutist. As I said, there is an element of truth to most market anomalies. If you want to incorporate them into your portfolio, here are my six recommended precautions:

1. Be sure there’s logic underpinning the strategy. In other words, make sure it isn’t a case of correlation without causation. Please don’t bet on sunspots.

2. Use funds. It’s hard enough to make these strategies work. You definitely don’t want to also be buying and selling hundreds of individual securities.

3. Keep your bets small. Many people—me included—believe that small-cap and value stocks will deliver better performance over time. Still, I recommend just a modest tilt toward these stocks when building a portfolio. Never put all your chips on one corner of the market, no matter how compelling the historical data.

4. Be selective. Some of these anomalies run counter to each other—like putting on a coat and then turning on the air conditioner. Be careful if you’re thinking of adding more than one to your portfolio.

5. Manage taxes. If you’re buying a fund that pursues any kind of active trading strategy, be sure to hold that fund in a retirement account, where there won’t be a tax impact.

6. Be patient. The worst thing an investor can do is to make a bet and then sell out when the bet starts to sour. When you’re betting on anomalies, you should expect periods of underperformance—potentially long periods. That’s another reason to keep your bets small. That way, your losses should never be large enough to force you into selling at an inopportune time.

Adam M. Grossman’s previous articles include Divvying Up DollarsLess Than the Truth and No, I’m Better.  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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