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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%
Clearly, selling in May would have been frustrating this year. But what if you had? If you sold at May 2017 market levels, could you bring yourself to buy back in now or would you wait longer? For what? When would you buy back in? What if the market doesn’t correct to May 2017 levels for another three years? What if it never does? Put yourself in this position and try to answer these questions – even if you didn’t sell it’s a great exercise. You see, trying to time the market is so difficult because it doesn’t just involve one decision (when to sell) but a second decision (when to buy back in!).
Successful short-cuts can reinforce bad behaviour
It’s also useful to flip this exercise around. What if global markets had gone down by the same amounts? Would you be better off if you’d sold in May? We’re not so sure. When would you feel good about buying back in? If the markets were all down %4.5+ since May we can assure you the headlines and market commentary wouldn’t be encouraging you to buy back in. On the contrary, they’d be screaming that markets were going down another 5% and fast! Even if you nailed it and bought back in now and markets started to rise would you really be better off in the long run? We’d argue that the feelings of confirmation and confidence you’d experience from this one “good decision” would bias your decisions in the future possibly to your detriment!
While rules of thumb or heuristics are incredibly useful to us in many aspects of our lives, be careful when searching for short-cut success with your investments!
Graham Bodel is the founder and director of a new fee-only financial planning and portfolio management firm based in Vancouver, BC., Chalten Fee-Only Advisors Ltd. This blog is republished with permission: the original ran on December 8th, here.
