By Generational Wealth AdvisorsJan 13, 2020, 05:00 et
Does anyone remember January 2016? The first two weeks of that month were the worst in the history of the S&P 500, with the index down almost 8%.
The month ended with the index down nearly 5%, the ninth worst January since 1926. Predictably, this spawned numerous articles about the predictive power of returns in January – one of the many definitions of the so-called “January Effect” that played on the fear of investors.
PREDICTING RETURNS IS DIFFICULT
At the time, we examined the S&P 500 index data from 1926 through 2015 and compared January returns to the subsequent 11-month return (February - December) each year. We found that when January returns were negative, the balance of the year was positive 59% of the time - hardly a reliable indicator.
Then, we looked at the five worst January returns to date and found that the average return for the balance of these years was 13.8% - well above the long-term return of the index.
It’s been a few years since we examined the data, so let’s see what has happened more recently. In 2016, as we mentioned, the S&P 500 lost 4.96% in January. But, the balance of the year was quite different, with a positive return of 17.81%. In 2017, the index had a positive return of 1.90% in January and the balance of the year was also positive, at 19.56%.
What about 2018, a down year for the index? In January, the index was up 5.73%, but the rest of the year was disappointing - down 9.56%. Finally, let’s look at the most recent full year of data from 2019. In January, the index was up 8.01% and the balance of the year was up 21.73%.
So, for the four years since we last examined the data, January returns predicted the balance of the year exactly half the time. This is what you would expect from a random event and a coin flip would have had the same predictive power. This is a classic example of recency bias - the expectation that we can extrapolate future events based on what has just happened. It’s how our brains are wired, so it’s not surprising that we often jump to this type of conclusion. However, data can provide clarity.
THINKING – FAST AND SLOW
Daniel Kahneman won the Nobel Memorial Prize in Economic Sciences in 2002 for his work that showed how human errors often arise from heuristics and biases. In his best-selling 2011 book “Thinking, Fast and Slow”, Kahneman explains that we each have two modes of thinking. Psychologists refer to these as “System 1” and “System 2”. System 1 operates automatically and quickly, with little effort and no sense of voluntary control. System 2 allocates attention to the mental activities that demand it, including complex analysis.
When making decisions about your portfolio, slow down and let your System 2 take control.
Whether you're looking to sell your business, are seeking advice on wealth management, or just want more information on the latest state of the market, you can view our Q4 2019 Annual Market Review to find out more.
1. In US dollars. Source: S&P.
2. Past performance is no guarantee of future results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Diversification does
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