Busting Market Myths

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Busting Market Myths
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
March 9, 2004

Investors are often bombarded with so-called investing “wisdom,” passed around the market from trading floors through the relentless media—and even coming from the occasional taxi driver. Have you heard any of these anecdotes about the stock market?

The January effect: Stocks do better in January, especially small-cap stocks.
The September effect: Bad things happen in the market when portfolio managers return from their vacations.
Sell in May and go away. Does the market really underperform during the summer?
The weekend effect: Stocks, much like our spirits, rise on Fridays and fall on Mondays.
The Super Bowl winner can predict the next year’s market performance. The New England Patriots hope that’s not the case; after all, the theory is that an AFC winner means bad news for the market.
If a Republican is in the White House, will stocks rise?
But don’t stocks do well during the third and fourth year of each Presidential term?
And what about years ending in five? If the stock market always rises in a year ending in five, how can you use that? Invest only every fifth year?

Imagine if you acted on all these myths. Your investing strategy would be: buy stocks every fifth year, but only if there’s a Republican in the White House—and it’s not the first or second year of his term—and if the NFC team won the Super Bowl—then make sure you’re in small-caps in January—go long on Fridays—and short on Mondays? And, get out of the market each September? Such a strategy would be ridiculous — if it was even possible.

So how do the myths stack up? Let’s look at a few:

The January effect
It’s true that stocks tend to do well in January, with small-cap stocks typically performing better than large-caps. We looked at two hypothetical portfolios. The first portfolio invested solely in large-caps. The second invested in large-caps 11 months of each year, but then switched to small-caps for the month of January.

We found that over the past 78 years, the portfolio that switched in and out of small-caps just for January would indeed have outperformed the portfolio that was just large-cap. But the risk of that portfolio was also higher. Small-caps carry higher risks as a tradeoff for those higher rewards. And, switching back and forth each year could generate unnecessary short-term taxable gains and transaction costs that would eat into the amount of money left to compound over time.¹

Sell in May?
The folklore says, “Sell in May and go away: come back by Saint Leger’s Day,” which comes from England and advises investors to cash in gains before the summer and then buy back at the famed Saint Leger’s Day horse race at Doncaster in mid-September. While the origin of this myth is English, that hasn’t stopped it from being transported across the pond.

Possible sources for the myth include the English tax year ending in April or portfolio managers vacationing all summer. However, we found that the highest returning month for the S&P 500 Index historically has been July. So if you’d sold in May, you’d have missed almost a century of July gains. And in the bigger picture, the ending wealth of a $100 buy-and-hold investment in the stock market in January of 1926 would have been almost four times that of an investment that followed a seasonal strategy of winter in the market, summer in cash.²

To be fair, though, there are some periods where this strategy would have worked well. Using 20-20 hindsight, we find that getting out of the market in the summer months would have benefited us particularly well in the 1970s. But we’re not actually convinced that’s a seasonal strategy at all, because the ’70s included one of the most severe bear markets—getting out of the market and into cash would have provided higher returns regardless of the month.

The September effect
September is indeed one month that historically has a greater percentage of falling months than rising. However, what about great Septembers like 1996, when the market was up almost 6%? Or September 1998, when the market was up 6.4%? And, if you’re continually getting in and out of the market, what about the erosion of investable funds due to transaction costs and taxable events? That could be considerable.

So how does market mythology come about? In this age of information and 24/7 media, investing’s like any other topic with a large base of interested fans. Just like it seems we have a non-stop supply of sports-talk radio, financial markets capture the mind and attention of many. It’s often entertaining and can help sell magazines, but shouldn’t be the basis for any strategic shifts in your portfolio.

Schwab’s always advocated a disciplined, long-term investment strategy, and we believe that will serve you better over time than jumping in and out of the market according the latest myth. Staying invested over the long-term can save you from unwanted taxable events, unnecessary transaction costs, and excessive time in monitoring your portfolio.

Moderation is key
As with many things in life, moderation is the key. Small tactical shifts in a diversified allocation are fine; at Schwab, we recommend no more than 5%-10% shifts. Of course, any tactical shift should be based on a well-thought-out viewpoint—not some market myth that may be pure coincidence and not based on a statistically causal relationship.

Whenever you’re tempted to time the market according to some myth, remember this final piece of research: We looked at the past 10 years of the S&P 500, and then looked at what happened to an investor who mis-timed the market and missed out on the top 10 days. Staying in the market would have netted over 11% annually over those 10 years. Missing only the top 10 days during that period (that’s 10 of more than 2,500 trading days) would have dropped that return to just 6% annually. And missing the top 20 days would have dropped that return to about 2%—which is below even Treasury bills. Are you willing to take the chance that your market myth won’t miss these top days?

Missing a few trading days can hurt—S&P 500, 1994-2003³

Investors need to distinguish between entertainment, interesting trivia and items that should truly be acted upon. Investing’s like a mosaic; all pieces of information taken together should help shape a decision, but no individual piece can tell the whole story. Don’t let market myths be the sole driver of a major portfolio decision.

1 Source: Schwab Center for Investment Research® with data from Ibbotson Associates, Inc. Analysis uses index monthly total returns from January 1926 through December 2003. Asset classes are represented by the S&P 500 Index (large-cap stocks) and the CRSP 6-10 Index (small-cap stocks). Results assume reinvestment of dividends and interest.

2 Source: Schwab Center for Investment Research® with data from Ibbotson Associates, Inc. Monthly returns for the S&P 500 Index are used to represent the market, with monthly returns of the Ibbotson U.S. 30-day T-bill Index used to represent time out of the market (cash). Results assume reinvestment of dividends and interest. A $100 investment in the market at the beginning of January 1926 would have been worth $228,479 at the end of December 2003. A $100 investment that was in the market November through April and out of the market May through October would have been worth $59,569 at the end of the same period.

3 Source: Schwab Center for Investment Research® with data provided by Standard & Poor’s. Data is annualized based on an average of 252 trading days within a calendar year. The year begins on the first trading day of January and ends on the last trading day of December and daily total return index closing levels were used for the period 1994 through 2003. Results include reinvestment of dividends.

Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

Past performance is no indication of future results.

Small-cap stocks are subject to greater volatility than other asset categories.

The Schwab Center for Investment Research is a division of Charles Schwab and Co., Inc.

Investment strategies, including diversification, do not assure a profit and cannot protect against losses in a declining market.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

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