Portfolio management
The way of pricing
This post is about the old investment adage ‘sell in May and go away’. The stock market is up a lot over the last five months and May is upon us.
My stimulus to write about this was an article I read last week in the Globe and Mail Report on Business which is Canada’s equivalent of the Wall Street Journal.
The article
The piece was written by George Athanassakos who is Professor of finance and the Ben Graham Chair in Value Investing at the Ivey Business School at the University of Western Ontario.
After noting the market rise this year, the author suggests that even value investors will be worrying about macro and global risks and offers the view that, based on historic market action, a lot of portfolio managers will be heavy sellers of equities in line with the adage ‘sell in May and go away’.
His advice is that selling in May can “provide profitable investment opportunities – especially if one reinvests those stock sales into government bonds until the end of October.”
The article offers evidence of a seasonal pattern in the form of 60 years of price data. It follows this up with a discussion of the likely cause. He suggests that the pattern is the result of money managers rebalancing portfolios and engaging in window dressing in pursuit of their own selfish agendas. He concludes that the signal may be particularly strong this year to ‘sell in May and go away’.
Three points
- The advice recommends market timing which is a no no. It is actually contrary to Ben Graham’s basic principle of buying value. The issue is how to deal with market fluctuation.
- The purported statistical support is based on the Law of Small Numbers supported by a plausible suggestion of cause.
- The advice comes from an academic.
Market fluctuations
Chapter 8 in Ben Graham’s classic book, The Intelligent Investor, is titled ‘The Investor and Market Fluctuations’. Graham warns of the dangers of trying to practice market timing. Market timing is the effort to buy a stock or stocks when the outlook is good and sell them when the outlook darkens. It is one of the most sure-fire ways of losing money in the stock market. It comes freighted with all the perils of behavioral biases.
Graham writes: “The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p95
Benjamin Graham makes a distinction between ‘the way of timing’ and ‘the way of pricing’. He writes: “Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.” (Graham, 1973) p95
This quote makes clear that the way of pricing is not market timing. Graham goes on to develop his thesis of the way of pricing and ultimately calls it buying with a margin of safety.
In a word, trying to follow the adage ‘sell in May and go away’ is to practice market timing. You could dress it up a bit and call it dynamic asset allocation so that one lightens up on stocks and switches to bonds depending on one’s outlook for stocks compared to bonds and then switch back later.
The law of small numbers
Prof. Athanassakos writes in the Globe and Mail article that his research shows that, for his suggested strategy, the average annual rate of return over a 60-year period would have been 17 percent and suggests the phenomenon is caused by money managers’ selfish agendas.
This seems to be a classic case of what Danny Kahneman calls our very human tendency to overgeneralize and find causes. Most readers will know that Kahneman was a psychologist who was awarded the Nobel prize in economics. He calls this, with a smile and nod to the statistical law of large numbers, the law of small numbers. Chapter 10 of Thinking Fast and Slow is titled ‘The Law of Small Numbers’.
As Kahneman puts it: “The strong bias toward believing that small samples closely resemble the population from which they are drawn is also part of a larger story: We are prone to exaggerate the consistency and coherence of what we see. The exaggerated faith of researchers in what can be learned from a few observations is closely related to the halo effect, the sense we often get that we know and understand a person about whom we actually know very little. System 1 runs ahead of the facts in constructing a rich image on the basis of scraps of evidence.” (Kahneman, Thinking, Fast and Slow. 2011) p114
Sell in May and go away is coming up with a story that is simpler and more coherent than the data justify. As well, there is the ever-present danger of data mining. That is, selecting a data set from amongst many that happens to produce the result looked for, for a very specific time frame. Yes, I know, the stock market often goes down between May and October. That doesn’t make it a valid strategy.
If it was this easy, why wouldn’t hedge funds be there one step ahead of us to make the easy profit. They wouldn’t leave any crumbs on the table for the rank and file.
Investors are bombarded daily with the opinions of analysts, advisors, pundits, journalists and bloggers purporting to be based on conclusions drawn from statistical analysis. Typical would be an opinion that the stock market is likely to advance next year. The reason given might be the assertion that when the S&P 500 has advanced more than 20% in a year, it is likely to advance the following year. The proffered evidence might be that, historically, the stock market has advanced 20% or more 17 times and that 14 of those occasions were followed by an advance the following year. What credence can we give to this prediction?
Investors are not trained statisticians. How can we sort the wheat from the chaff? The first step has to be to recognize purportedly statistics based inductive reasoning for what it is. This is easier said than done. But any conclusion drawn from an analysis of data should cause investors to immediately raise their guard.
Sound statistics can help us to tame massive amounts of confusing data. It is the inexpert use and misuse of statistics that causes problems.
Remember, the good professor’s advice was to sell in May and reinvest “those stock sales into government bonds until the end of October.” Good luck with that market timing. Ben Graham would not have approved. What possibly could go wrong?
Professors and the stock market
Let me offer a few thoughts about expertise and the stock market. If I ever wanted to get advice or an opinion about where the stock market will go between May and October, there is only one person I would pay attention to, that is Warren Buffett. And, he would never offer such an opinion. So, how can a professor of finance offer such an opinion?
With the advent of computers about 60 years ago mathematicians/statisticians with a finance bent went to work on the stock market. Some extraordinary theories and hypotheses were developed by some very bright and talented young academics and generations of finance graduates were trained on those ideas. These theories and hypotheses took hold and for the last 60 years they have had a major influence on investors from the most dedicated quant to individual investors. The best-selling book on investing of all time was written by Professor Burton Malkiel of Princeton University, (1973,2007) A Random Walk Down Wall Street. Over I million copies were sold. It espoused the extraordinary theories and hypotheses with monikers like EMH, MPT, beta and so on.
Warren Buffett didn’t think much of these theories and hypotheses. He wrote: “Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. To invest successfully, you do not need to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.” (Buffett, 1998, p.93) (Emphasis added)
I have nothing against professors. As with any expert you have to know where their expertise lies. You could be really smart and could read a hundred books about investing. That would make you knowledgeable about investing but it would not, by itself, make you a good, let alone a great, investor. Skill in investing only comes with experience. Academics may or may not have investing experience and may or may not have investing skill. Opinions and advice are only worth listening to if that are based on true expertise.
My point, very simply, is that just because the article was written by a finance professor at a well-regarded school of business, doesn’t mean you should rely on the advice.
I do not know Professor Athanassakos. I know nothing about his academic qualifications nor about his investing experience. I can only say I respectfully disagree with what he advises in the article.
Wall Street has lots of adages. There are the Dogs of the Dow and the January Effect to mention two others. I suspect some of these were favorites of stock brokers happy to earn commissions from the buying and selling these generated. Selling stocks in May and buying bonds generates commissions. Reversing the positions in October would generate more commissions. And, every sale or purchase faces the headwind and added cost of buy/ask spreads.
Conclusion
I was struck by the advice in the article. It was not something I was contemplating doing. The idea of selling some stocks in May and buying bonds with the plan of going back into the market in October struck me a market timing. Market timing is a game for speculators and traders. It is not a game for investors. True investors can take advantage of market swings and volatility by use of what Ben Graham calls the ‘way of pricing’.
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The ‘sell in May’ adage has to do with when you should sell a stock. The following post gives some guidance:
19 Cardinal rules on selling stocks
To dig into the problem that we tend to generalize from limited observations check out this post. It has suggested rules to avoid the problem.
A set of rules to develop a behavioral edge – Part 6
Here’s another posts focusing on the problem investors have with statistics.
Finally, two posts that are self explanatory.
Experience and becoming a really successful investor
Investing when others are fearful
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Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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Want to dig deeper into the principles behind successful investing?
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