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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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Pravin Mittal
Pravin Mittal
1 year ago

Small caps and value stocks are riskier than overall market so on average has provided better historical return. It is congruent with risk-return tradeoff so not a anomaly. Eugene Fama himself explained this in one of his interviews.

Thomas
Thomas
1 year ago

Aside from the Fama-French factors, are there any other anomalies for which there is solid, publicly available empirical data?

I’m somewhat hesitant to tilt my portfolio with small-cap value stocks. I just don’t have the save conviction that they will generate alpha as I do that a total market fund will grow in the long-run. I suppose that doubters like myself are part of the reason why these factor premiums might still exist (although this remains to be seen: https://ofdollarsanddata.com/death-of-a-value-investor/).

MutantDog
MutantDog
1 year ago

I am recently drawn to the 25 year old perception that growth in the Internet space is relatively unconstrained by the physical limits to growth which may impede some industries. Since the topic has become ‘factor’ styles, have you ever worked the problem of the more-or-less virtual corporation being a ‘factor’.

Market Map
Market Map
1 year ago

A decent signaling correlation, one that has marked the commencement of periods of high probability positive forward 1, 2, and 5 year market returns, involves a combination two empirically derived data series: the occurrence of a high ranking, large “quarterly market loss” followed by a cross of the S&P500 index “above” its 10 period monthly basis moving average ( price / moving average cross a measure that has been cited in academic research ).

There have been 11 occurrences since 1932, most recent being May 29 2020
( Table 1 * )

Armed with this knowledge, a “spending” stage investor, looking to harvest a higher level of income from an investment portfolio than what is recommended in the conventional financial blogosphere and media outlets, can review a study put forth by legendary investor Peter Lynch in Worth magazine in 1995.
https://www.worth.com/from-the-archives-fear-of-crashing/

The premise underlying the study describes the ability of an investor in taking as high as a 7% annual income withdrawal rate off of a portfolio constructed using large cap dividend paying ( value ) companies, using a dividend received and sales of shares regime, with the portfolio surviving and sustaining the withdrawal rate ( accompanied
by portfolio balance growth ) over forward 20 year scenarios.

Fast forward a few years to the 21st century, and an investor can use a low expense funds, representative of large cap dividend growth stocks and, commencing with the advent of a high ranking “worst quarterly market loss / S&P500 price moving average cross, proceed with a “buy and hold” 10 years of 7% income withdrawal, instilled with the confidence resulting from the portfolio surviving over nine historical 10 year returns periods ( chart 10 * ), ex income withdrawal.

One can also employ the use of duration assets with the portfolio to create a “balanced” type portfolio ( Chart 11 * ) which has resulted, because of duration assets “drag” on the portfolio’s return, in a single 10 year period ending below starting balance ( 1932 – 1942 ).

It appears that the signaling correlation described has occurred near the “end” of a significant market decline, therefore presenting a “lower risk” opportunity towards taking “higher” level of income from a portfolio.

* https://tinyurl.com/y9uv8nl6

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