6 years since 1925 when large stocks haveoutperformed small stocks in January. Furthermore, when small stocksunderperform large stocks, it is usually not by much: the worst underperformance was 5.1 percent in January 1929. In contrast, since 1925,small-stock returns have exceeded large-stock returns in January by atleast 5 percent for 28 years, by at least 10 percent for 13 years, and byover 20 percent for 2 years.The January Effect also prevailed during the most powerful bearmarket in our history. From August 1929 through the summer of 1932,when small stocks lost over 90 percent of their value, small stocksposted consecutive January monthly returns of plus 13 percent, 21 percent, and 10 percent in 1930, 1931, and 1932. It is testimony to the powerof the January Effect that investors could have increased their wealth by50 percent during the greatest stock crash in history by buying smallstocks at the end of December in those three years and selling them atthe end of the following month, putting their money in cash for the restof the year!A fascinating feature of the January Effect is that you do not have towait the entire month to see the big returns from small stocks roll in.Most of the buying in small stocks begins on the last trading day of December (often in the late afternoon), as some investors pick up the bargain stocks that are dumped by others on New Year’s Eve. Strong gainsin small stocks continue on the first trading day of January and with declining force through the first week of trading. On the basis of researchpublished in 1989, on the first trading day of January alone, small stocksearn nearly 4 percentage points more than large stocks.3 By the middle ofthe month, the January Effect is largely exhausted.When any anomaly such as the January Effect is found, it is important to examine its international reach. When researchers turned to foreign markets, they found that the January Effect was not just a U.S.phenomenon. In Japan, the world’s second-largest capital market, theexcess returns on small stocks in January come to 7.2 percent per year,3
Robert Haugen and Josef Lakonishok, The Incredible January Effect, Homewood, Ill.: Dow JonesIrwin, 1989, p. 47.
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more than in the United States.4 As you shall see later in the chapter, January is the best month for both large and small stocks in many othercountries of the world.5How could such a phenomenon go unnoticed for so long by investors, portfolio managers, and financial economists? Because in theUnited States, the returns in January are nothing special for large stocksthat form the bulk of those indexes that are analyzed. That’s not to saythat January is not a good month for large stocks, as large stocks do quitewell in January, particularly in foreign markets. But in the United States,January is by no means the best month for stocks of large firms.
Causes of the January EffectWhy do investors favor small stocks in January? No one knows for sure,but there are several hypotheses. In contrast to institutions, individualinvestors hold a disproportionate amount of small stocks, and they aremore sensitive to the tax consequences of their trading. Small stocks, especially those that have declined in the preceding 11 months, are subjectto tax-motivated selling in December. This selling depresses the price ofindividual issues. In January after the selling ends, these stocks bounceback in price.There is some evidence to support this explanation. Stocks that havefallen throughout the year fall even more in December and then often risedramatically in January. Furthermore, there is some evidence that beforethe introduction of the U.S. income tax in 1913, there was no JanuaryEffect. And in Australia, where the tax year runs from July 1 through June30, there are abnormally large returns to small stocks in July.If taxes are a factor, however, they cannot be the only one, for theJanuary Effect holds in countries that do not have a capital gains tax.Japan did not tax capital gains for individual investors until 1989, butthe January Effect existed before then. Furthermore, capital gains werenot taxed in Canada before 1972, and yet there was a January Effect inthat country as well. Finally, stocks that have risen throughout the pre4See Gabriel Hawawini and Donald Keim, “On the Predictability of Common Stock Returns:World-Wide Evidence,” in Robert A. Yarrow, Vojislav Macsimovic, and William T. Ziemba, eds.,Handbooks in Operations Research and Management Science, vol. 9, North Holland, 1995, Chap. 17, pp.497–544.5For an excellent summary of all this evidence, see Gabriel Hawawini and Donald Keim, “TheCross Section of Common Stock Returns: A Review of the Evidence and Some New Findings,” in Security Market Imperfections in Worldwide Equity Markets, Donald B. Keim and William T. Ziemba, eds.,Cambridge, England: Cambridge University Press, 2000.
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vious year and should not be subject to tax-loss selling still rise in January, although not by as much as stocks that have fallen the previous year.There are other potential explanations for the January Effect. Workers often receive extra income, such as from bonuses and other forms ofcompensation, at year-end. These individuals often invest their cash instocks in the first week of January. Data show that there is a sharp increase in the ratio of public buy orders to public sell orders around theturn of the year. Since the public holds a large fraction of small stocks,this could be an important clue to understanding the January Effect.6Although all these explanations appear quite reasonable, none jibeswith what is called an “efficient capital market.” If money managersknow that small stocks will surge in January, these stocks should bebought well before New Year’s Day to capture these spectacular returns.That would cause the price of small stocks to rise in December, whichwould prompt other managers to buy them in November, and so on. Inthe process of acting on the January Effect, the price of stocks would besmoothed out over the year and the phenomenon would disappear.Of course, to eliminate the January Effect, money managers and investors with significant capital must know of the effect and feel comfortable about acting on it. Those in a fiduciary position might feeluneasy justifying what appears to be a very unusual investment strategyto their clients, especially if it does not work out. Others might be reluctant to take advantage of a phenomenon that seems to have no clear economic rationale.
The January Effect Weakened in Recent YearsPerhaps all the publicity about the January Effect has motivated tradersto take advantage of this calendar anomaly since the effect has been farweaker since 1990 than before. From 1990 through January 2007, the average January return on the Russell 2000 Index has been 1.36 percent,only slightly more than the 0.70 percent return on the S&P 500 Index.Furthermore, the return on the Russell 2000 on the last trading day ofDecember and the first trading day of January, which had previouslybeen so high, has been no higher than the S&P 500 Index, and both havebeen approximately zero. Finally, the excess return on small stocks during the first seven trading days in January, which had been so large before 1990, has also vanished.6
Jay Ritter, “The Buying and Selling Behavior of Individual Investors at the End of the Year,” Journal of Finance, vol. 43 (1988), pp. 701–717.
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There has, however, been a bit of revival of the January Effect in recent years. Since 2000 the return on small stocks has risen to 1.68 versus0.21 percent for large stocks. This is not as big as the historical advantage,but it is far larger than that in the 1990s. Perhaps the poor performance ofthe January Effect during that decade caused traders to ignore the phenomenon, and the anomaly has resurfaced. We all await further data.
LARGE MONTHLY RETURNSThere are other seasonal patterns to stock returns besides the January Effect. The monthly returns on the Dow Industrials and S&P 500 Index aredisplayed in Figure 18-2. December has been the best month since WorldWar II for both indexes, but only the fifth-best month since 1885. In striking contrast, August, which was the best month for the past 116 years, isactually the second-to-worst month since World War II for the Dow andthird-worst month for the S&P 500 Index. Since the end of World War IIthere has been really no evidence of the “summer rally” that used to bemuch trumpeted by brokers and investment advisors.These monthly patterns of returns have a worldwide reach. Although January is a good month in the United States, it is an excellentmonth in most foreign countries. The January returns for the 20 countriescovered by the Morgan Stanley Capital Market Index are shown in Figure18-3. In every country, January returns are greater than average and constitute nearly one-quarter of the annual stock returns abroad. Investor enthusiasm in January also seems to infect the neighboring months ofDecember and February. Well over one-half of all returns outside theUnited States occur in the three months of December through February.7
THE SEPTEMBER EFFECTSummer months have good returns, but after the summer holidays,watch out! September is by far the worst month of the year, and in theUnited States, it is the only month to have a negative return includingreinvested dividends. September is followed closely by October, which,as Chapter 16 indicated already, has a disproportionate percentage ofcrashes.7
The data presented in Figure 18-3 are from a value-weighted stock index calculated on largestocks. As noted previously, there is evidence that smaller stocks experience even higher January returns, so the January returns shown in Figure 18-3 are probably much lower than those that can begained in the average stock.
FIGURE
18–2
Monthly Returns on the Dow Jones Industrials and the S&P 500
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FIGURE
313
18–3
International January and September Effects, 1970 through December 2006
Shown in Figure 18-4 are the Dow Jones Industrial Averages from1885 through 2006, both including and excluding the month of September. An investment of $1 in the Dow Jones Average in 1885 would beworth $490 by the end of 2006 (dividends excluded). In contrast, $1 invested in the Dow only in the month of September would be worth only23 cents! On the other hand, if you put your money in the stock marketevery month except September, your dollar would have been worth$2,176 at the end of 2006.The poor returns in September also prevail in the rest of the world.It is amazing that September is the only month of the year that has negative returns in a value-weighted index. September has been the worstmonth in 17 of the 20 countries analyzed and all the major world indexes,including the EAFE Index and the Morgan Stanley all-world index. InSeptember investors would do better holding zero-interest currency than
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FIGURE
18–4
The September Effect: Dow Jones Industrial Average, 1885 through December 2006
putting their assets in the stock market. Furthermore, in contrast to theJanuary Effect, the September Effect has not only prevailed since 1990 butit has actually been stronger over the past 16 years. It is curious that theJanuary Effect has received all the publicity while the September Effectremains strong with very little research to date.We can only speculate on why returns are so poor in September.Maybe the poor returns have nothing directly to do with economics butare related to the approach of winter and the depressing effect of rapidlyshortening daylight. Psychologists stress that sunlight is an essential ingredient to well-being: recent research has confirmed that the New YorkStock Exchange does significantly worse on cloudy days than it does onsunny days.8 But this explanation falters “down under” as September is8
Edward M. Saunders, Jr., “Stock Prices and Wall Street Weather,” American Economic Review, vol. 83(December 1993), pp. 1337–1345.
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also a poor month in Australia and New Zealand, where the monthmarks the beginning of spring and longer days.9Perhaps the poor returns in September are the result of investors’liquidating stocks (or holding off buying new stocks) to pay for theirsummer vacations. As discussed below, until recently Monday was byfar the worst-performing day of the week. For many, September is themonthly version of Monday: the time you face work after a period ofleisure.
OTHER SEASONAL RETURNSAlthough psychologists say that many silently suffer depression aroundChristmas and New Year’s, stock investors believe ’tis the season to bejolly. Over the past 120 years, daily price returns between Christmas andNew Year’s, as Table 18-1 indicates, have averaged 10 times the average.9
TABLE
Of course, many investors in the Australian and New Zealand market live north of the Equator.
18–1
Dow Jones Industrial Average Daily Price Returns, February 1885 through December 2006
1885 - 2006 1885 - 1926 1926 - 1945 1946 - 1990 1990 - 2006Overall AveragesWhole MonthFirst Half of MonthSecond Half of MonthLast Day of Month
0.0238%0.0428%0.0048%0.0998%
0.0192%0.0203%0.0182%0.0875%
0.0147%0.0621%-0.0316%0.1633%
0.0273%0.0500%0.0040%0.1460%
0.0400%0.0606%0.0199%-0.0831%
-0.0946%0.0386%0.0613%0.0246%0.0672%0.0701%0.0637%0.0578%
-0.0874%0.0375%0.0280%0.0012%0.0994%0.0994%
-0.2106%0.0473%0.0814%0.0627%0.0064%0.0064%
0.1240%0.0512%0.0409%-0.0038%-0.0077%0.0961%-0.0077%
0.0348%
0.0964%
-0.1313%0.0307%0.0909%0.0398%0.0942%0.0826%0.0961%0.0962%
0.3154%0.3510%0.3099%0.3254%0.2412%
0.2118%0.4523%0.5964%0.4201%0.3242%
0.8168%0.3634%0.3931%0.5244%0.2875%
0.2746%0.3110%0.2446%0.2767%0.1828%
0.0809%0.1959%-0.3101%-0.0111%0.0746%
Days of the WeekMondayTuesdayWednesdayThursdayFridayWith SatWithout SatSaturday
Holiday ReturnsDay before HolidayJuly 4thChristmasNew Year'sHoliday AvgChristmas Week
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Even more striking is the difference between stock returns in the firstand second half of the month.10 Over the entire 122-year period studied,the percentage change in the Dow Jones Industrial Average during thefirst half of the month—which includes the last trading day of the previous month up to and including the fourteenth day of the current month—is almost nine times the gain that occurs during the second half.11The average percentage changes in the Dow Jones Industrial Average over every calendar day of the month are shown in Figure 18-5. It isstriking that the average percentage gain on the last trading day of themonth (and the thirtieth calendar day, when that is not the last tradingday) and the first six calendar days is more than equal to the entire return for the month. The net change in the Dow Industrials is negative forall the other days.The strong gains at the turn of the month are probably related to theinflow of funds into the equity market from monthly pay cycles. Although this phenomenon has attenuated in recent years, the return inthe first half of the month is still more than three times the return in thesecond half of the month since 1990.
DAY-OF-THE-WEEK EFFECTSMany people hate Mondays. After two days of relaxing and doing prettymuch what you like, having to face work on Monday is a drag. Andstock investors apparently feel the same way. Monday has been by farthe worst day of the week for the market. Over the past 121 years, the returns on Monday have been decisively negative—so negative that ifMonday returns were instead like Tuesday through Friday, the Dow Industrial Average would have reached 68 million today!Although investors hate Mondays, they have relished Fridays. Friday has been the best day of the week, yielding price returns about threetimes the daily average. Even when markets were open on Saturday(every month before 1946 and nonsummer months before 1953), Fridayprice returns were the best.The Monday and Friday effects are not confined to U.S. equity markets. Studies by Keim and Hawawini have shown that throughout most10
R. A. Ariel, “A Monthly Effect in Stock Returns,” Journal of Financial Economics, vol. 18 (1987), pp.161–174.11The difference in the returns to the Dow stocks between the first and second halves of the monthis accentuated by the inclusion of dividends. Currently, about two-thirds of the Dow Industrialstocks pay dividends in the first half of the month, which means that the difference between the firstand second half returns are accentuated even more.
CHAPTER 18 Calendar Anomalies
FIGURE
317
18–5
Daily Price Returns on the Dow Jones Industrial Average, 1885 through December 2006
of the world, Monday is a poor day, garnering negative returns not onlyin the United States but also in Canada, the United Kingdom, Germany,France, Japan, Korea, and Singapore. On the other hand, none of themajor countries have negative returns on Wednesday, Thursday, or Friday. Tuesday is also a poor day for the market, especially in Asia andAustralia.12 This might be due to the poor Monday just experienced inWestern countries, since daily returns in the United States have beenfound to influence Asian markets the next day.But the daily pattern of stock prices has changed dramatically.Since 1990 Monday has gone from the worst to the best and Friday fromthe best to the worst. This pattern might be an overreaction by traders tothe widespread publication of the daily data during the 1990s. Knowing12
These results are taken from Hawawini and Keim, “On the Predictability of Common Stock Returns,” pp. 497–544.
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Monday is usually a bad day, traders sell the Friday before and buy backstock on Monday. Whatever the reason, it shows that, like the JanuaryEffect, well-publicized anomalies are often arbitraged out of the market.Another calendar anomaly is that stocks do very well before majorholidays, as shown in Table 18-1. Price returns before the Fourth of July,Christmas, and New Year’s are, on average, almost 14 times the averagedaily price return. But this anomaly, like the day-of-the-week effect, haschanged dramatically in recent years. Although stock returns on the daybefore July Fourth and Christmas have remained strong, returns on thelast day of the trading year have switched from a strongly positive 0.31percent to a decisively negative 0.31 percent since 1990. The negative returns on the last trading day in recent years are probably caused by a largenumber of “sell-on-close” orders that are automatically executed to offseta position in stock index futures. The downward movement of stockprices generally occurs in the last 30 minutes of trading. Of course, it islikely that once this pattern becomes widely known, it too will disappear.Finally, there appears to be a diurnal pattern of stock returns. Evidence has shown that there is usually a sinking spell in the morning, especially on Monday. During lunch the market firms, then pauses or declinesin the midafternoon before rising strongly in the last half hour of trading.This often leads the market to close at the highest levels of the day.
WHAT’S AN INVESTOR TO DO?These anomalies are an extremely tempting guide to formulating an investing strategy. But these calendar-related returns do not always occur,and, as investors become more aware of them, some have moderatedwhile others have disappeared altogether. Still others have completelyswitched, such as the behavior of stocks on the last trading day of the year.Furthermore, investing in these anomalies requires the buying andselling of stock, which incurs transactions costs, and unless you are trading with tax-sheltered funds, you may realize gains that could be taxed.Nevertheless, investors who have already decided to buy or sell but havesome latitude in choosing the timing of such a transaction, might wish totake these calendar anomalies into account before making their trades.
19
CHAPTER
BEHAVIORAL FINANCE ANDTHE PSYCHOLOGY OF INVESTINGThe rational man—like the Loch Ness monster—is sighted often, butphotographed rarely.D AV I D D R E M A N , 1 9 9 8 1
The market is most dangerous when it looks best; it is most invitingwhen it looks worst.FRANK J. WILLIAMS, 19302
This book is filled with data, figures, and charts that support an internationally diversified, long-term strategy for stock investors. Yet advice ismuch easier to take in theory than to put in practice. The finance profession is increasingly aware that psychological factors can thwart rationalanalysis and prevent investors from achieving the best results for theirportfolio. The study of these psychological factors has burgeoned intothe field of behavioral finance.1
David Dreman, Contrarian Investment Strategies: The Next Generation, New York: Simon & Schuster,1998.2Frank J. Williams, If You Must Speculate, Learn the Rules, Burlington, Vt.: Freiser Press, 1930.319Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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This chapter is written as a narrative to make it easier to understand the basic research and issues of behavioral finance. Dave is an investor who falls into psychological traps that prevent him from beingeffective. You may notice similarities between his behavior and yourown. If so, the advice given in this chapter should help the reader become a more successful investor. Dave first talks to his wife Jennifer andthen to an Investment Counselor who understands behavioral finance.The narrative begins in the fall of 1999, several months prior to the peakin the technology and Internet bubble that dominated markets at theturn of the century.
THE TECHNOLOGY BUBBLE, 1999 TO 2001TIME: OCTOBER 1999
Dave: Jen, I’ve made some important investment decisions. Our portfolio contains nothing but these “old fogy” stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren’t doing anything rightnow. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of thesestocks. He said the experts think the Internet is the wave of the future.I’m selling some of our stocks that just aren’t moving and getting intothe Internet stocks like Amazon, Yahoo!, and Inktomi.Jennifer: I’ve heard that those stocks are very speculative. Are you sureyou know what you’re doing?Dave: Allan says that we are entering a “New Economy,” spurred by acommunications revolution that is going to completely change the waywe do business. Those stocks that we owned are Old Economy stocks.They had their time, but we should be investing for the future. I knowthese Internet stocks are volatile, and I’ll watch them very carefully sowe won’t lose money. Trust me. I think we’re finally on the right track.TIME: MARCH 2000
Dave: Jen, have you seen our latest financial statements? We’re up 60percent since October. The Nasdaq crossed 5,000, and no one I’ve heardbelieves it will stop there. The excitement about the market is spreading,and it has become the topic of conversation around the office.Jen: You seem to be trading in and out of stocks a lot more than you didbefore. I can’t follow what we own!Dave: Information is hitting the market faster and faster. I have to continuously adjust my portfolio. Commissions are so cheap now that it
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pays to trade on any news affecting stocks. Trust me, look how wellwe’re doing.TIME: JULY 2000
Jen: Dave, I’ve looked at our broker’s statement. We don’t hold those Internet stocks anymore. Now we own (she reads from the statement) Cisco,EMC, Oracle, Sun Microsystems, Nortel Networks, JDS Uniphase. Idon’t know what any of these companies do. Do you?Dave: When the Internet stocks crashed in April, I sold out right beforewe lost all our gains. Unfortunately, we didn’t make much on thosestocks, but we didn’t lose either.I think we’re on the right track now. Those Internet companiesweren’t making any money. All the new firms we now own form thebackbone of the Internet and all are profitable. Allan told me an important principle: Do you know who made the most money in the CaliforniaGold Rush of the 1850s? Not the gold miners. Oh, some of the early diggers found gold, but most found nothing. The real winners from the GoldRush were those that sold supplies to the miners—pick axes, boots, pans,and hiking gear. The lesson is very clear, most of the Internet companiesare going to fail, but those supplying the backbone of the Internet—therouters, software, and fiber optic cables—will be the big winners.Jen: But I think I heard some economist say those companies are wayoverpriced now; they’re selling for hundreds of times earnings.Dave: Yes, but look at their growth over the last five years—no one hasever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don’t apply. Trust me; I’ll monitor thesestocks. I got us out of those Internet stocks in time, didn’t I?TIME: NOVEMBER 2000
Dave (to himself): What should I do? The last few months have beendreadful. I’m down about 20 percent. Just over two months ago, Nortelwas over 80. Now it is around 40. Sun Microsystems was 65, and now itis around 40. These prices are so cheap. I think I’ll use some of my remaining cash to buy more shares at these lower prices. Then, my stocksdon’t have to go up as much for me to get even.TIME: AUGUST 2001
Jen: Dave. I’ve just looked at our brokerage statement. We’ve been devastated! Almost three-quarters of our retirement money is gone. I
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thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.Jen: This has happened before. I don’t understand why you do so badly.For years you watch the market closely, study all these financial reports,and seem to be very well informed, yet you seem to always make thewrong decisions. You buy near the highs and sell near the lows. You holdon to losers while selling your winners. You . . .Dave: I know, I know. My stock investments always go wrong. I thinkI’m giving up on stocks and sticking with bonds.Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They usebehavioral psychology to help investors understand why they dopoorly. The investment counselor will help you correct this behavior.Dave, I made you an appointment already. Please go see him.
BEHAVIORAL FINANCETIME: NEXT WEEK
Dave was skeptical. He thought that understanding stocks requiredknowledge of economics, accounting, and mathematics. Dave neverheard the word psychology used in any of those subjects. Yet he knew heneeded help, and it couldn’t hurt to check it out.Investment Counselor (IC): I have read your profile and talked to yourwife extensively. You are very typical of the investor that we counselhere. I adhere to a new branch of economics called behavioral finance.Many of the ideas my profession explores are based on psychologicalconcepts that have rarely before been applied to the stock market andportfolio management.Let me give you some background. Until recently, finance wasdominated by theories that assumed investors maximized their expected utility, or well-being, and always acted rationally. This was an extension of the rational theory of consumer choice under certainty applied touncertain outcomes.In the 1970s two psychologists, Amos Tversky and Daniel Kahneman, noted that many individuals did not behave as this theory predicted.They developed a new model—called prospect theory—of how individualsactually behave and make decisions when faced with uncertainty.3 Their
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model established them as the pioneers of behavioral finance, and their research has been making much headway in the finance profession.
Fads, Social Dynamics, and Stock BubblesIC: Let us first discuss your decision to get into the Internet stocks. Thinkback to October 1999. Do you remember why you decided to buy thosestocks?Dave: Yes. My stocks were simply not going anywhere. My friends atwork were investing in the Internet and making a lot of money. Therewas so much excitement about these stocks; everyone claimed that theInternet was a communications revolution that would change businessforever.IC: When everyone is excited about the market, you should be extremelycautious. Stock prices are not based just on economic values but on psychological factors that influence the market. Yale economist RobertShiller, one of the leaders of the behavioral finance movement, has emphasized that fads and social dynamics play