Is the ‘October Effect’ real?

The human mind is the biggest obstacle to on-going, long-term successful investing. It’s a phenomenon that impacts not one investor, but many, all across the world — for an entire month. Welcome to the ‘October Effect’.

It’s been another volatile October! What is it about October over all other months? The stock market crash of 1929 started in October and ushered in the Great Depression. Black Monday 1987, also October, was driven by computer trading and portfolio insurance and in October 2008, the S&P 500 Index lost nearly 17% — the biggest monthly decline of the GFC.

Few would know but there was also a minor panic in October of 1907, during which the Dow Jones Index lost 15%.

It’s no surprise for those that subscribe to the ‘October Effect’ – the belief that the stock market often declines in October.

There are many theories about the stock market, and the October Effect is just one. Each is compelling and difficult to resist, especially when being explained by a keen proponent. On the other hand, logic suggests that if any were correct, all investors would soon follow and it would lose its impact.

The October Effect

Besides the October falls mentioned above, between 2009 and 2017 we experienced three October declines, each losing just under 2%. In the six periods that saw an advance, the S&P 500 averaged a 5.3% advance.

This year was different. In October the S&P 500 Index gave up 6.9%.

Even though many think that it was the result of the October Effect, the 2018 price fall could have been the result of a number of factors, or a combination. The US market has had a 10-year bull run without a correction, whereas corrections occur on average twice every decade. Investors are getting nervous. The Fed chairman Jerome Powell’s comments that the fed funds rate is “…a long way from neutral at this point”, alludes to the fact that China is slowing down and growth in Europe has softened, implying that firms doing a significant share of business with these regions could face reduced profits. These concerns, together with the nervousness around October, can cause price falls.

Investors who believe in the October Effect would completely discount the S&P 500’s 8% advanceinOctober2015, or the fact that from 1970 the broad-based index of 500 major US stocks has averaged a gain in October. In fact, October ranks number three in performance when using the median return.

In case you’re wondering, on average, September is the weakest month.

But why does it really happen?

My view is that there is, in fact, no difference between October and any other month. The October theory is based less on evidence and more on what psychologists call ‘availability’ — the human tendency to judge how likely an event is by how easily we can recall vivid examples of it; and framing, where “people react to a particular choice in different ways depending on how it is presented”.

Defensive assets generally do better and stock analyst earnings forecasts are less optimistic in autumn and winter — the darker months.

In other words, investor psychology is the real explanation of price volatility. Successful investors are those able to not only understand the psychology of investing but also be aware of when it’s having an impact on themselves and others.

Human beings find it remarkably difficult to simply allow a set of facts to exist in a vacuum. There is always a need to create a story to explain the facts.

It happens all the time

The S&P 500 lost 9.9% from closing peak to trough (20 Sept to 29 Oct) and although it’s never pleasant to watch the value of a portfolio fall, the fall was actually quite modest.

A fall in prices during the year is not uncommon. Since 1980, the average drop from peak to trough in the stock market during the year has been 14% and in recent years, we’ve experienced a number of sell-offs. The stock market has weathered Brexit, the European debt crisis, China worries, the Ebola scare, the Japan earthquake/tsunami/nuclear disaster, US debt downgrade, and much more.

When in doubt, rely on what’s indisputable

Shares are much higher today and over time will continue to rise. Capitalism is one of the laws of humanity (in my personal opinion), and capitalism suggests that companies as a whole will continue to make a profit and will, therefore, have a long-term upward bias. The over-optimism or pessimism of human beings will be reflected in the prices, and those that can discount both and resist the illogical theories will avoid bad decisions and benefit the most over the long term.

Decisions should be based on factors that can be explained and are easy to understand, not on fanciful theories — even though they are sometimes fun to hear.