Financial markets seem to lend themselves to sayings and myths. The natural human desire to seek order in chaos and to condense complex issues into simple formulae leads to a whole series of catchy phrases that many believe will give you an advantage in trading and investing. Unfortunately, as is so often the case, analysis suggests that the reality is just not that simple. Here are a couple of the more common things you will hear about trading and investing, both of which are currently relevant, with a look at the logic and evidence that contradicts them.
Sell in May and Go Away: A phrase that reportedly has its origins among Wall Street traders and which, at one time seemed to have a grounding in logic. When most or all stock trading was done by open outcry on the exchange floor, the theory was that when the summer months came and traders began to focus on vacations the market would fall due to a simple lack of interest.
On the surface that may sound plausible, but if you stop and think it through even the underlying “logic” quickly falls apart. Market pricing simply reflects the last price at which a buyer and seller agreed to transact and that means that both parties must exist for a trade to take place. For a lack of interest to equate to a drop in the market therefore only the potential buyers would have to take vacations.
The actual evidence of recent years also supports the contention that the logic is flawed. Over the last ten years selling at the beginning of May and staying in cash for the next three months would have returned a profit five times and a loss five times. In other words, the chances of it being a successful strategy are the same as picking a stock entirely at random and then flipping a coin to decide whether to sell or buy.
Don’t Try to Catch a Falling Knife: Another old saying that seems to make sense on the surface. It is used to caution against a contrarian trading style. The basic theory is that when a stock, or a market in general has fallen significantly it should be left alone as buying on the drop is too dangerous.
At times, of course, that is sound advice. If a company or an industry is in an existential crisis then there is no such thing as value, and the logical bottom to a fall is zero. Much of the time, however, even sharp declines are the result of the market’s tendency towards group think, and when that is the case contrarian trading in a controlled manner is a perfectly viable strategy. I spent nearly twenty years in dealing rooms all over the world and I can assure you that many traders have made a career out of bottom fishing in a disciplined manner.
The trick in that kind of situation is to understand the risk/reward ratio of such a trade. If you get it right and buy something that is being dragged down past any logical point by fear and the resultant momentum, then the potential rewards are huge. You may only get such a trade right one time out of five or so, but if you understand that and use fairly tight stop loss orders to protect against the likelihood that you will be wrong, that occasional win will be big enough to still make the trading style profitable.
The problem with myths such as these is that they are oversimplifications. There are many influences on financial markets, and while attempting to distill those things into simple sayings is tempting, it is not a wise thing to do. The satirist and late night TV host Stephen Colbert once identified a tendency in American political thought towards what he labelled “truthiness”: believing things that “feel” right despite evidence to the contrary. That is also a danger for investors, and questioning any saying, no matter how true or relevant it may seem at first glance, is a good practice to adopt.