Typically, during the summer six-months period of May through October, the U.S. stock market under performs the remaining six-month period of November through April.
According to the Stock Trader’s Almanac, since 1950, the Down Jones Industrial Average has had an average return of only 0.3% during the May-October period, compared with an average gain of 7.5% during the November-April period.
Every year around this time, the popular press gets all excited will bring up the issue of whether you should “sell in May and go away”. They always have some justification for making a forecast and they like to pretend they can predict the future.
And every year, I get asked by friends and investors if there’s any truth to this adage.
Especially this year.
This year the S&P 500, a good representation of the US stock market, is up a whopping 10.5% year-till-date (as of April 29th).
Considering that the market was up strongly in the past couple of years and then gave back all the returns in May, should we at least consider selling in May and going away?
No, we shouldn’t. While the average return has been 0.3%, it might very well be 7%.
You shouldn’t try to time the market.
No one can reliably or consistently predict when the market will top, and conversely, when it will bottom. If they could, they surely wouldn’t be sharing their secrets with the press, or bother managing your money.
Secondly, if you’re invested in a well-diversified portfolio, you don’t even need to worry about timing the market.
A well-diversified portfolio has allocations to many different sectors — U.S. stocks, international stocks, emerging market stocks, commodities, real estate and bonds, just to new a few.
While the S&P 500 may have had a terrific year so far, the rest of the market has been lagging.
Bonds and international stocks are flat, emerging market stocks have lost a few percent, and commodities have seen a major decline.
So while the largest stocks in the US have had a great year, the other sectors have not.
If you’re using a financial advisor, you’re probably in a well-diversified portfolio with specific allocations to various sectors.
This portfolio was carefully chosen for your unique situation by considering your personal finances, your risk tolerance, and investment objectives.
If your advisor is like me, he spent a lot of time and effort constructing a custom portfolio that’s forward looking, and attempted to match the market (or a benchmark return) with less volatility. (Being able to match a benchmark return with less volatility is called improving the Sharpe Ratio of a portfolio. The Sharpe Ratio is the only way to do a true apples-to-apples comparison of two portfolios, but that’s a topic worthy of a separate discussion).
Hopefully, he’s not just creating a portfolio of last year’s winners that is rebalanced once a year in to the current batch of “last year’s winners”. Performance chasing never works and only serves to generate fees for certain types of brokers.
Regardless, he would regularly rebalance your portfolio to bring it back in line with your target allocations.
What is rebalancing? It’s where you sell some of your winners, and use the proceeds to buy some of the losers. Yes, it sounds counter-intuitive, and no one likes to sell a winner and buy a loser. But it’s been academically proven to increase returns while reducing the volatility of the portfolio.
Nothing goes up forever. Sooner or later, your winners will fall. And your losers will outperform the market.
Take Apple (AAPL) for instance. It’s down 20% this year. Meanwhile, Microsoft (MSFT), which has gone nowhere for a decade, is suddenly up 23% in the same time frame.
It’s impossible to determine which stock, or sector, is going to outperform in the short-term.
Supposing you had a 35% allocation to US large-cap stocks in your portfolio. The 10.5% rise would mean nearly 39% of portfolio was now in that sector. If you sold just 4% and reallocated to the sectors that had underperformed, you would effectively be selling high and buying low.
This is one of the few true secrets to making money in the stock market. Yes, it’s that simple. You use a rebalancing system to sell high and buy low.
A study by Crestmont Research shows that infrequent rebalancing in a bull market adds 0.3% return. However, during a bear market, frequent rebalancing adds 1.3%. Yale Endowment stated that regular rebalancing added 1.6% return in 2003.
Let’s say over the next six months, the largest U.S. stocks did in fact decline 5%. Meanwhile the other sectors in your portfolio appreciated beyond their target allocation. In six months time, you’d again rebalance and sell some of the winners to buy back the same sector you sold in April – the largest U.S. stocks. Just in time for the November – April run up in prices.
On the other hand, if the largest U.S. stocks didn’t decline, but instead continued their upward ascent, the 35% of your portfolio that was allocated to them would benefit from that exposure.
In a way, you get the best of both outcomes without choosing a preference.
This is the strategy we follow for our clients, as well as our personal portfolios. Of course, our strategy is slightly more complicated. We use a proprietary system that considers percentage threshold, time and standard deviation in rebalancing.
It may be a simplistic idea, but it’s academically proven to work over the long term. In fact, it’s the same method followed by large billion-dollar endowments.
The two most common complaints to rebalancing are trading costs and taxes. We’ve managed to eliminate the excess trading costs by using a brokerage company that charges our clients a flat monthly fee, regardless of number of trades. And since for a majority of people, the majority of their investments are held in retirement accounts, taxes aren’t an issue either. We also use tax-loss harvesting to minimize the effects of taxes in non-retirement accounts.
The only real drawback to rebalancing a well-diversified portfolio is that it might underperform in an extended bull market. But, as any investor who has been investing for several years knows, nothing goes up forever. If you manage risk well, you don’t have to stretch for returns.