Five stock market anomalies seem to be able to beat the market but are they good long-term investing strategies?
We don’t talk much about trying to beat the market here on the blog because most investors have a horrible record of success.
The average investor underperformed the market by nearly 5% over the decade to 2010 from trying to beat the market. Panic and euphoria cause people to jump in and out of stocks at exactly the wrong time.
But there is one type of investing strategy that seems to consistently lead to higher returns. These ‘market anomalies’ like the January Effect are researched changes in the market that you might be able to take advantage of to boost your returns.
Market anomalies are trends in stock returns that tend to reoccur every year. Some say that you shouldn’t be able to beat the market with anomalies because everyone would pile into the investment ahead of time and erase any benefit to the trend.
The reality is that some market anomalies do survive even as the market becomes aware of the opportunity and can add thousands to your portfolio each year.
Playing market anomalies feels a little like trying to play the professionals’ game, which we talked about as the wrong way to win the stock market game, but there may be something to it.
The January effect is the most well-known market anomaly but I wanted to take a look at the entire list to see if they could be built into a long-term investing strategy.
Calendar Market Anomalies to Beat the Market
Calendar market anomalies are the most famous among investors. The idea is that some months typically mean higher or lower stock returns compared to others.
The most famous of these is the January Effect. The idea is that stocks that did poorly in the fourth quarter (October – December) tend to outperform in January. As with most market anomalies, there is good rationale that drives the trend to reoccur each year.
Investors usually sell their losing stocks towards the end of the year to use the losses against gains in other stocks and lower their taxes. This puts extra selling pressure on stocks that have underperformed during the year. When investors come back in January, there’s no additional selling pressure on last year’s losers and the valuations look attractive which leads to a rebound.
Another popular market anomaly is the idea of ‘sell in May and go away’ or that the market tends to underperform during the summer months. Trading volume is lower during the summer as investors go on vacation but it’s difficult to point to a reason why this would put downward pressure on stock prices.
Looking at historical monthly returns provided by Yardeni Research helps to see the reality behind the January Effect and other calendar market anomalies.
There does seem to be some evidence of market anomalies if we look at the number of up and down months going back nearly 90 years. The list below shows the number of times the market has been up or down in the strongest four months and the weakest three months.
- December 64/24
- January 55/34
- March 55/34
- April 55/34
- June 48/49
- February 47/42
- September 39/48
While the number of up and down months is pretty close for most, December is a runaway positive and September is overwhelmingly down more often than up. The first chart below shows the average percent gain or loss during each month. The second chart shows the average overall return by month over the 88-year period.
It’s difficult to come to any real conclusions based on monthly data. January, April, July and December all look to be fairly positive months for stocks. February, May and September seem to be the months in which stocks perform poorly.
The problem with the January Effect and calendar anomalies is that they ignore so many other factors that determine stock prices. Using calendar anomalies on a regular basis to pick stocks also means trying to put together all the other economic pieces of the puzzle to beat the market.
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Small Firm Market Anomaly
Another stock market anomaly says that smaller companies tend to outperform the huge market behemoths. Comparing the Russel 2000 index of small companies against the S&P 500 index of mega-cap firms, we do see that stocks of smaller players often jump higher.
The reason stocks of smaller companies tend to do better, if not for just a little while, makes economic sense. Small companies can respond more quickly to customer needs and changes in their product market. Smaller companies also benefit from a lower base for growth relative to larger companies.
A $500 million company only needs $50 million in additional sales to book growth of 10% while a rival like $397 billion Microsoft would need to boost sales by $39 billion to book the same growth.
There is a problem with what’s called survivorship bias when looking at the small cap market anomaly. Small companies that go bust are removed from the data, removing their poor performance from the group.
It’s clear though that there is some benefit to investing in smaller companies. When the economy is healthy and the stock market is rising, small caps will generally do better than larger companies. When the market tumbles though, small cap stocks get hit harder and fall faster.
The benefit here for long-term investors is that you don’t have to worry about short-term losses when small cap stocks tumble. It makes the adage to buy when there’s ‘blood in the streets’ even more apt. When the markets are tumbling and small cap stocks are falling faster, it makes even more sense to buy for your long-term portfolio.
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Low Book Value Market Anomaly
Another market anomaly is that stocks with low price-to-book market values tend to outperform. This is one of the market anomalies I like to call the ‘duh’ anomalies. It would make sense that cheaper stocks would do better than more expensive stocks, right?
This stock anomaly holds up for price-to-earnings as well where stocks with cheaper P/E ratios tend to do better than more expensive peers. The anomaly is weaker than the others on the list though so isn’t really a good predictor for investing.
I’m a value investor at heart so always like to buy stocks that are cheaper than their peers anyway. If everything else is relatively equal as in growth rates and profitability, who wouldn’t rather invest in the cheaper stock rather than one that is expensive.
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There are two warnings though for investing in the low-cost market anomaly. First, don’t forget to compare stocks on other factors besides just a low price-to-book or P/E ratio. There may be a good reason the stock is valued more cheaply. Is sales growth lower or did headlines come out that may point to a weaker business going forward?
You also need to be comparing valuations among stocks within the same sector and industry. Stocks of financial companies generally trade for much lower price multiples when compared to technology stocks or healthcare companies.
If you only screened for low P/E values, you would end up with a portfolio almost entirely invested in just a couple of sectors. Instead, look for a couple of low price stock picks from each sector to build a diversified portfolio.
Neglected Firms Market Anomaly
The neglected firm market anomaly is similar to the small firm effect. Wall Street analysts don’t usually research or give opinions on very small companies with market caps under $1 billion. This means there isn’t as much information known and not as many investors willing to take a chance on a company they know little about.
The result is that when these companies do well, they tend to beat other stocks by a wide margin. The downside is that there is also the risk that these companies will crash completely and you’ll lose all your money.
The problem with the neglected firms’ anomaly is that it requires so much more research to invest successfully. Since there is not the library of analyst estimates and research, you have to go directly to the companies’ financial documents to make your own analysis. This is tough to do if you don’t know what you’re looking for or how to put together a valuation.
Buy Low, Sell High Market Anomaly
The final market anomaly is sometimes called market reversal. It seems that stocks that did really well or really poorly over the prior 12-month period tend to reverse direction in subsequent months.
Research backs up the idea and it also makes fundamental sense. Stocks that did really well last year benefited from a lot of investor enthusiasm on the way up. Reasons for the price to keep going up may be wearing thin and the valuation relative to earnings is probably high compared to peers. When investor sentiment starts to fall, there’s fewer new buyers and the shares start to head lower.
It can happen with last year’s losers as well. Investors have sold out of the shares on all the bad news that is available and only the long-term investors are left. The stock is relatively cheap against competitors and any good news will help shares increase.
Technical Trading versus Types of Stock Market Anomalies
There is a difference between technical trading in stocks and investing on market anomalies.
Technical trading is buying or selling on very short-term signals, usually stock price patterns that last only a few days or weeks. There are some longer-term signals but most technical strategies will mean buying and selling an investment within a month or two.
Technical trading generally applies to individual stocks. Traders will analyze the price movement over a few days against historical patterns in an attempt to catch very short-term changes from the average.
In contrast, market anomalies usually apply to the broader market. This might mean the entire stock market during a certain period of the year or sections of the market like small cap stocks.
While I have very little faith in most technical trading strategies, there does seem to be some evidence for higher returns with market anomalies.
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How to Use Stock Market Anomalies to Beat the Market
I wouldn’t generally recommend trying to beat the market, whether by trading on stock market anomalies or other ideas. It is much more important to lay out a personal investment plan that accounts for your own financial goals and a long-term investing strategy.
I’ve started covering more market anomalies like the Sell-in-May Stock Signal on My Stock Market Basics lately but still have my doubts that they are appropriate for most investors.
Don’t get me wrong, I do believe that a few market anomalies may be able to get you a few percent extra a year.
There are a couple of problems with trading stocks on market anomalies that make them poor investing strategies for many investors.
- Selling an investment less than 12 months after you bought it means you’ll pay a higher tax rate, your income rate instead of lower capital gains taxes. That eats into the returns reported by studies showing the benefits of market anomaly strategies.
- Most investors just want a stress-free approach to reaching their financial goals. Trying to play the market with several different strategies just complicates investing. Investors start to feel like they are forced to spend hours a week on investing and get tired of it, ditching the market all together.
My best recommendation, and this is from more than a decade working with individual investors and big money firms, is to separate your investments into two buckets.
- The majority of your money, around 70% to 80% of your investments, are put in a buy-and-hold approach and mostly in broad-based exchange traded funds (ETFs)
- The remaining portion can be invested in individual stocks and through strategies like market anomalies.
This gives you the opportunity to watch your money grow with the stock market but with less work and stress than trying to constantly move your whole portfolio around according to short-term strategies.
Prepare your strategy for the long-term and observe markets and anomalies closely, but objectively. Implement a trading system which fits to market anomalies in your and better use stop losses. Remember that you are not trying to catch the last cent of an anomaly, but actually trying to make money over decades without going broke. Don't forget that shorting is risky as well. You will need patience and determination. And if a trade doesn't work out at first glance, you simply have to wait for a better opportunity.
If a trade doesn't work out, don't procrastinate and try to “fix it”. Simply wait for the next opportunity. Don't use leverage; it's very expensive if you are wrong, and will erode your equity. Don't blame brokers (or yourself) because the market is not behaving normally or fitting your belief systems/likes/dislikes etc. Always put 50% of your capital in safe investments like CDs, Savings Bank Accounts and money markets; that way, you won't go broke if one lucky shot goes wrong. Sometimes, when you see an anomaly that fits everything perfectly, it may be a trap. Look further to see if there is something that invalidates your rational view of the anomaly, and don't go for it. You must keep track of all investment decisions. This way, you can learn from mistakes, which are the best way to make profits long term.
You can fit market anomalies into your long-term investing strategy though as a way to help guide some of the stocks you buy. Try investing in some smaller companies and stocks with low price valuations when you put your money to work. Consider rebalancing your portfolio in December or January to take advantage of calendar anomalies. Whether you can beat the market with these anomalies is subject to opinion but the should help you to do well over the long-term, especially the ones with real rationale for why they beat the market.
Read the Entire Investing in the Stock Market Series
- Four of these Sample Stock Portfolios Beat the Stock Market
- How Do Stocks Work? And Other Stock Market for Beginner Questions
- 3 Shocking Ways the Stock Market is Rigged Against You
- How to Protect Your Money from a Stock Market Crash
- How to Invest Your Money in the Stock Market