Behavioral Finance

Stay in May

By, 04/23/2007

Here it comes. Expect to be bombarded in the coming week with the aphorism, "Sell in May, go away!" Otherwise perfectly rational adults with unfettered access to the Internet and reasonable competency on a solar-powered pocket calculator believe with their souls the summer months are an anathema for stocks. Tie that with currently-popular fears about slowing earnings and a possible recession, and selling in May might seem appealing.

Should investors cave to this bit of investing folklore? First and foremost, as we've said in this space repeatedly, we expect both growth and earnings to surprise to the upside. Folks are altogether too dour (providing a nice wall of worry for stocks to climb). That said, is there any reason to expect stocks to take a nap just because the kids are off from school?

As always, a good place to start is asking, "What do I believe that's wrong?" Is it true summers are bad for stocks? This isn't hard—you can find annual returns for the S&P 500 from a number of finance web sites. Yearly returns on the S&P 500 have averaged about 12.2%. The summer months have averaged 4.7%—a superior three-month period if the year returns just over 12%.In other words: Don't sell in May.

Maybe we're looking at this wrong. Sell in May adherents argue it's not the summer months that are bad, but the summer half of the year. In other words: Sell in May, go away, come back, and buy in November. (You can see why they chose to go with the shorter version. Much pithier.)

Fine. But our trusty calculator tells us May through October has averaged 4.4% and the other half 7.4%. It's true! The summer half does have inferior returns! But what does this information tell you? Stock returns are not serially correlated. Glance at monthly or quarterly stock returns, and you see plenty of variability. Market returns are far from average—average returns are extreme. Knowing the summer half has averaged 4.4% in no way instructs you how to allocate for the coming months. An average is just an average.

For a moment, let's pretend we can reasonably predict future stock returns using past averages. What can we do now? Do we sell in May, hold cash or bonds, and buy back in November? Absolutely not—that would still be irrational. Even a half-year return of 4.4% would beat the respective historical averages of cash or bonds. Why hold a poorer performing asset class for six months when sticking with stocks is likely to net a higher overall return? When you factor in transaction costs and taxes from buying and selling twice a year, your portfolio would take an even bigger hit.

We can't explain why November to April have had historically better average returns than May to October. Statistics are funny, and stocks have wild, erratic returns over short periods. But the facts are plain: You are far better served remaining in the stock market than gambling on a historic average—particularly when that average still beats your other options.

Why do so many investors cleave to this bit of mythology? Behavioralists call this cognitive error "confirmation bias." Our brains tend to cling to bits of data supporting our preset notions or prejudices, and dismiss contradictory data. When stocks have a gloomy summer, our brains want to say, "Yep, that's what I expected—more evidence that summers are crummy for stocks." But when the reverse is true, we excuse that by reframing. We justify the contradictory evidence by saying, "Of course it cannot always be true. You must look at a longer time period." Or a different time period. Or we say it's not the summer months, but the summer half of the year. We get creative so we may dismiss the contradictory evidence and be comfortable that we were right all along.

Ditch this mythology and stick with your stocks.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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