Sunday, June 24, 2007

Sell in May and Go Away

The 2% drop in the S&P500 last week brings to mind the old Wall Street aphorism - "Sell in May and Go Away." The assumption behind the saying is a solid one -- the summer action in the markets is generally unproductive for investors. Recent academic studies lend credence to this saying.

A small study I did for the 14 years from 1994 through 2004 yielded the following monthly average returns for the 10 largest Northern Hemisphere stock markets:
When you look out further in history, as the authors (Ben Jacobsen and Sven Bouman) of an excellent 2001 study have done, the data supports the "Sell in May and Go Away" pattern: "Surprisingly, we find this inherited wisdom to be true in 36 of the 37 developed and emerging markets studied in our sample. The 'Sell in May' effect tends to be particularly strong in European countries and is robust over time. Sample evidence, for instance, shows that in the UK the effect has been noticeable since 1694." The study shows that, on average, a buy-and-hold investor would do approximately as well as a "Sell-in-May-and-Go-Away" investor (holding stocks from November 1st to April 31st).

Other researchers have theorized that this effect is biological in origin. In the paper "Winter Blues: A SAD Stock Market Cycle" the authors find that the seasonal effect is more pronounced at higher latitude stock markets (such as Stockholm) where sunlight waxing and waning is more pronounced, and it is inverted in Southern hemisphere stock markets (such as Sydney) where seasons are reversed. In fact, a Stockholm to Sydney portfolio rotation (to match the late Fall to early Spring cycle) earned over 20% annually. Investing in each market (Stockholm or Sydney) alone throughout the year earned about 13%. The authors point out that "Seasonal Affective Disorder", a type of depression that is most pronounced in the late summer and early fall, has a similar cycle as the stock market.

In a more recent 2005 study, the seasonal effect was found to be pronounced worldwide in IPOs and earnings revisions, as if investors' expectations become overly optimistic during the Fall and Winter and then come back to reality in the Summer. This hypothesis of optimism fits with the biological hypothesis, as increased optimism is a hallmark of increased seasonal serotonin and dopamine levels in the brain.

All of these studies indicate that the old aphorism may really be true. Summer is an excellent time for reflection and research, and it will only rarely be a peroid of high returns.


Thursday, June 21, 2007

Know When to Fold 'Em: What Makes an Investor Great

I love poker, particularly Texas Hold 'Em. If you're unfamiliar with the game, just turn on the TV. The chances are, it's on right now - on 37 different channels.

The game provides a great diversion, especially when you make a night out of it with friends, but more than that, it provides valuable self-insights into one's investing behavior -- if you're inclined to look.

Poker, like investing, is a game of decisions made with incomplete and unfolding information. Being good at it requires the same set of skills - patience, discipline, guts, and the ability to filter out our own emotions.

There's an expression in poker; great players lay down great hands. In fact, the ability to accept a loss and get away from a great hand is probably the most important (and difficult) skill to learn. Here's a typical example.

Let's say you've been losing all night when you find yourself dealt a pair of Queens as your starting hand. "Yes! I'm getting paid on this one!", you say to yourself. So you bet. Two people call your bet.

Then the flop comes, revealing a 5, a 7 and a King. You don't like seeing that King, because anyone holding a King in their starting hand has you dead to rights now. But you decide to get aggressive, you bet again. This time one of the bettors folds his hand. The other calls your bet.

Next comes the turn, revealing an Ace. Uh-oh, now you're really in trouble. If the other player is holding either an Ace or a King... you lose. But your opponent bet with that King on the board so you figure that while they may have a King, there's no reason to believe they're holding an Ace. You decide to bluff. You bet again, this time with even more money. They player calls your bet again. Now most of your money is in the pot.

The river comes, it's a harmless 2. You're committed to winning this hand, you decide to put some pressure on the opponent, so you bet half of your remaining money. This time, the opponent, doesn't call. He raises you, forcing you all in. Every bone in your body is telling you, not to call. Even a novice player recognizes he or she is almost certainly holding a losing hand. But you've put so much money into the pot already (financial investment) and you still have a sliver of hope you can win and get your money back (emotional investment). You think, "What choice do I have?" You call.

You show your Queens, and the other player reveals a pair of Kings AND a pair of Aces. Damn. Their starting hand was Ace-King. They had you on the flop and on the turn. Game over.

In behavioral finance parlance this is called the Sunk Cost Fallacy - the refusal to get out of a losing position, because you've already written the money off -- resulting in losing even more money.

Those Queens were one of the best starting hands in the game (the third best actually). But it soon became apparent based on the subsequent cards and betting behavior that it was no longer the winning hand. Information changes, but our emotions sometimes don't get the memo. You know in your head to cut your losses. It's your gut that won't let go. We tell ourselves, in poker and in stock market investing "There's a chance it could come back and, what the heck, it's down so much, there's no sense in getting out now anyway."

The ability to take a small loss to avoid a big one is the hallmark of smart poker player. It's also the sign of a great investor.

So how do you do it? How do you overcome the natural temptation to "dig your way out of a hole".

You have to reframe the situation and retrain your mind. In other words, you have to learn to love to take losses. One way I do this is by using the expression above; "Great poker players lay down great hands" is what I use to do that. I tell myself, "Sure, I lost a little money. But I demonstrated the quality necessary to be a long-term winner." In other words, I pat myself on the back.

Think of it this way; all financial investing is an attempt to meet an emotional need. If you can let the emotional gain trump the financial loss, you've found the secret to acquiring those tough-to-form habits.

Does it always work? Well, no. In the spirit of honesty, I can tell you that sometimes I get frustrated and make a dumb call anyway. I suspect we all do. But the next time your impulsive stock purchase drifts down 10%, remember those two Queens. It may just help you fold that hand, and pick up an even bigger winner on your next hand. It is, afterall, a sign of greatness.

Wednesday, June 13, 2007

The News is....Do the Opposite of What the News Says

I was pleasantly surprised to see the US markets up substantially today -- "the biggest one day gain of 2007" the media report.

To what do we owe this great day? Well, if you follow the daily financial media reports, then you'll see a few reasons put forward for the price jump -- declining bond yields, increasing retail sales, and diminishing concerns about inflation.

But that's today. Yesterday, per the financial media, investors were frightened when the 10-year bond yield symbolically breached 5%. According to the AP Business Wire today: "Rising bond yields amid inflation concerns had been pummeling stocks since last week."

Too often, the media is unhelpful for investors. Explaining events after the fact means little for future prices. In fact, future prices tend to do the opposite of what the news implies.

When the media is negative is actually the best time to buy. The chart to the left demonstrates how negativity in the media, this time around 9/11 and the war in Afghanistan, was inversely correlated with market returns. I quantified negativity by counting negative words (fear-related) in the Nightly Business Report online transcripts. A simple regression analysis found a significant inverse correlation between the prevalence of negative words in a transcript and the market's performance over the next week. No offense Paul Kangas and Susie Gharib, but your broadcast is useless for the average investor.

By the way, the above chart appears in my upcoming book, "Inside the Investor's Brain" (available from Wiley on July 9th).

When amateur investors hear the media experts predict a slowing economy after a sharp drop in the market, they get scared. When scared, they are more likely to sell. The financial news is better avoided by sensitive investors - those who might get scared at exactly the wrong times.

The media has numerous rationalizations, on a day-to-day basis, for the market's volatility. Beware. Paying attention to this information can be detrimental to your wealth.


Monday, June 04, 2007

Like the Kids Say... OMG,TMI!

There's and old expression; "A little bit of knowledge is a dangerous thing".

I'd like to add a corollary; "and so is a lot".

I was curious to see what the Market would do on Monday (June 4, 2007), because of the two events that occured on the weekend: 1) The Shanghai Composite dropped 8.3% and, 2) A terrorist plot to blow up JFK airport (and much of Queens) was nipped in the bud.

Truth be told, I was hoping for a nice big drop so I could go bargain hunting. But it was not to be. Perhaps because enough people shared my reactions; 1) The Shanghai Composite is a small and not terribly significant market that is nearly 70% comprised of small Chinese citizen investors - it shouldn't matter that much to us; 2) Oh, terrorists are hatching plans to blow up New York? Really? Tell me something I don't know.

And The Market shrugged. (Damnit)

So it didn't create the buying opportunity, I'd hope for. What it did do was call to mind our strange and paradoxical relationship with financial information; that we want more of it... and that getting it usually hurts our financial decisions.

Knowing too much hurts a lot of our decisions. In his book, Blink, Malcolm Gladwell details how Cook County Hospital simplified their ER triage. Their model eliminated all but four pieces of data to determine whether to admit a patient for a heart attack (electrocardiographic evidence, presence of unstable angina, fluid in the lungs, and a cutoff point for systolic blood pressure). Any additional data - even data that look relevant such as weight, age, etc. -- and the decisions got worse. To borrow an expression from teen-speak, it's "TMI" (Too Much Information.)

No one has understood or exploited the human mind's unhealthy relationship with TMI better than the Gambling Industry.

Ever been a horse track? The helpful track owners provide information on lap times, finishes in previous races, breeding, performance in mud, or rain, on grass, on dirt, the record of the jockeys... they give you literally 100s of different variables to factor into your decision. Does it help? No! It's TMI. Many data points are simply red herrings. But the relationships between the variables are too complex, and the sample sizes usually too small, to make any meaningful conclusions anyway.

The gambling industry knows that most gambling information is specious; it looks important, but is useless for prediction. Sometimes they even know that we know. At a roulette table, the board above the wheel posts the last 20 or so numbers that came up. Nothing could be more irrelevant, and only the most naive player doesn't understand this. But people actually pay attention to what happened before! They love it! "Oh, look. It hasn't hit # 23 in a while!", or "It's been black 4 times in a row now!" Seeking TMI isn't just a human inclination, it's fun!

So what of investing? With Blackberries, Real Time Market Quotes... Jim Cramer, we have more information than we know what to do with. And it's available any time. How do we sift through the haystack of data to find the needles or relevancy?

It starts with an understanding that much of the information we encounter is like that on the roulette board - interesting, but irrelevant. It also means recognizing that, even with quality information, you can have too much of a good thing. Lastly, we can recognize that information that is Frequent, Emotional Evocative in content, and Recent are most likely to be overly influencial in The Market's short term decision-making. (I would say that the terrorist plot meets the last two criteria and the Shanghai drop meets all three). It's a great way to spot short term buying and selling opportunities.

Simplify. Avoid TMI.