At the end of April we wrote a piece looking at some new research on the calendar effect and popular heuristic known as Sell in May and go away.
While there is some evidence that this particular anomaly does exist and has persisted over certain periods of time, there is not really a good theoretical foundation for why it happens. Mining historical data often yields patterns but assuming that those patterns will repeat can lead to unfortunate investor strategies and behaviours.
It’s in our nature to love short-cuts
Investors just love short-cuts. In fact not just investors love them but people in general always use heuristics to help increase the efficiency of their decision-making. If you step outside, feel a sudden cool breeze and look up and see a dark cloud in the vicinity you respond fairly quickly and sensibly by seeking shelter or at least grabbing an umbrella as you head out the door. This ability to create short-cuts makes our lives so much easier and sometimes even keeps us safe. We recognize patterns that we’ve seen before, assume they’re going to happen again and act almost automatically in response: it simply makes decision-making faster and less difficult. No need to analyze things in detail, just act.
The challenge is that the same heuristics that make decision-making easier and faster or keep us safe in many aspects of our lives can also produce behavioural biases that don’t help us as investors. We love things like the “January effect” or “Sell in May and go away” because they’re easy and have sometimes worked in the past. But putting them into practice doesn’t always work out the way we might imagine.
But short-cuts don’t always work with investing
This year is a good case study. What if we had sold in May and stayed out of the market through until now? To cut to the chase, you wouldn’t be happy! A Canadian investor would have missed out on the following returns from May 1 until now (all in Canadian dollar terms – return data from S&P Indices Canada and exchange rates from Bank of Canada as at December 7, 2017):
S&P/TSX Composite Total Return Index: +4.6%
S&P 500 Net Total Return Index (in CAD): +4.7%
S&P Global ex-US Broad Market Net Total Return Index (in CAD): +4.8%
On October 19 Fortune published an article with the headline:
“30 Years after Black Monday, the Dow Hits an All-Time High”.
The article goes on to speculate:
“only time will tell if we have another crash ahead of us. But in the meantime, investors seem to think that skepticism and caution may be just what we need to avoid one.”
Connecting the all-time high to the Black Monday crash from over 30 years ago smacks of the kind of fear-driven nonsense that characterizes much of financial markets journalism these days. The article raises the temperature further by pointing out that:
“this marks the fourth thousand-point milestone for the Dow this year, painting a very different picture than what was seen in 1987. According to the Wall Street Journal, the Dow had never before hit more than two of these milestones in a year.”
Transforming meaningless data points into blood-pressure-raising insights is a coveted skill for both market journalists and stock market analysts alike. After all it’s their jobs to get people to act: stock analysts to compel trades, journalists to direct readers/viewers to the skilled money managers that advertise in their pages or on their programs.
I’d be a poor headline writer. The first one I came up with, “Dow Hits an All-Time High more than 500 Times Since 1987 Crash” wouldn’t inspire much fear or anything else. The fact is that markets go up most of the time as is clearly displayed in the index data series shown at the top of this blog, courtesy of Dimensional Fund Advisors. Continue Reading…
Stock market investors face a difficult challenge. While long-term stock market returns are quite attractive, in the short-term returns can be quite volatile.
This volatility can be difficult to stomach at times, especially when accompanied by worrying news flow.
Adding to the angst for Canadian investors can be the volatility of the Canadian dollar, yet it makes sense for Canadians to diversify globally. It is important from time to time to review the historical evidence to help us manage our behaviour and stick with our investment plans. Let’s review some of the long-term evidence:
“Long-term stock markets returns are quite attractive”
- The average annual return of the S&P/TSX Composite index of Canadian stocks over the 60 years between 1957 and 2016 is 9.1%
- The average annual return of the S&P500 index of large cap US stocks over the 91 years between 1926 and 2016 is 10%
- The average annual return of the MSCI EAFE index of developed market stocks outside North America over the 47 years between 1970 and 2016 is 9.1%
- Exposure to small-company stocks and low-valuation stocks has led to higher performance levels than that of market capitalization weighted indices over long periods of time
“In the short-term returns can be quite volatile”
“We see these approaches to managing people’s affairs through a private corporation as creating an unfair playing field … We’re trying to tighten these loopholes to make sure that it’s fair.”
Doesn’t sound like taxes for small business owners are going down, does it? The above is from federal finance minister Bill Morneau’s July 18 announcement outlining some of the measures the government is proposing to help level what they perceive to be an unfair playing field.
Since the announcement we’ve been thinking about the potential implications of these changes and digesting comments from a variety of different tax experts. We agree with one expert who opined that “fairness is subject to personal interpretation.”
Unfortunately adhering to these proposed changes won’t be subject to personal interpretation so the bottom line is that we encourage all small business owners, especially those using private corporations in conjunction with saving for retirement or for the benefit of their families as a whole, to seek expert tax advice ahead of these changes coming into effect.
How did this come about?
Taking a step back, the reason that small businesses were given preferential tax treatment in the first place was to encourage them to reinvest in growth opportunities, employ more people, contribute to the Canadian economy in a more meaningful way and that would be good for Canada – hard to argue with that.
Of course all rules, especially tax rules, end up with unintended consequences. The current government feels many small business owners and their families have been taking advantage of opportunities (loopholes) in the legislation that allow for further savings when it comes to their personal taxes. Furthermore, they seem to be particularly concerned about the increased “corporatization” of certain professions that has taken place over the last 10 to 15 years in order to reduce tax bills. As not everyone is a small business owner, the tax advantages are deemed to be unfair to those who aren’t.
What are the specific areas that are deemed to be unfair?
1.) Income sprinkling
Income sprinkling is a strategy where a business owner looks to save tax by distributing income, dividends and capital gains to other members of his or her family in order to take advantage of multiple sets of graduated tax rates (i.e. pay other family members who are in a lower tax bracket) or exemptions, in order to lower the overall family tax bill. Continue Reading…