Investors beware. Stock market statistics can often lead to fake news

Published in the Sunday Times on 29th August 2021.

I’ve always liked August. Mostly good weather, holidays and a very important birthday (I’ve just made it through another trip around the Sun). The stock market appears to like August too. According to Bill Schwert, Emeritus Professor of Finance at the University of Rochester, August has averaged the highest returns of any month at +1.45%. This is surprising; I’ve always believed that accolade belonged to January. A quick search on Google concurs.

Much has been written about the so-called January effect. Numerous books and research papers refer to it as the month with the best stock market returns. The most popular explanation for the January effect is tax management. This is the idea that investors sell loss-making shares just before the year-end to offset those losses against gains elsewhere, thereby lowering any capital gains tax liability. They then buy these shares back in January, leading to a wave of buying pressure. This seems like a reasonable explanation. But the data doesn’t support it. 

The August Effect

Schwert’s analysis is based on data that goes back to 1885, so these are long-term patterns. So, it looks more likely that there’s an August effect rather than a January one. And there’s an explanation for this that really appeals to me. I want to believe that stocks do better in August because nobody's paying attention. Trading desks are empty and investors are on holidays. Much like the Fidelity study that found the best performing accounts belonged to clients that had passed away or had forgotten they had them – there’s much to laud in inactivity. 

But as much as I’m drawn to this conclusion the most likely explanation is that it's just random variation. There may well be some seasonality to stock market returns, but in an efficient market, it is the triumph of hope over experience to think it will show up consistently. There is no story – other than how we are often misled by statistics. 

Misuse of stock market statistics

The use of statistics and the ability to mislead in all walks of life – not least financial markets – is rife. Some are innocuous, like exaggerated weight loss claims from snake-oil fitness or diet merchants. Some are more sinister. The tobacco industry’s use of statistics to sow doubt about the links with cancer in the 1960’s is disturbing. By the 1960s, there was conclusive medical proof of the links between smoking and cancer. The formidable tobacco industry sought to raise doubt about the evidence and was incredibly successful at it.

A leaked tobacco industry memo from 1969 is chilling in its unguarded truthfulness “Doubt is our product since it is the best means of competing with the body of fact that exists in the mind of the general public. It is also the means of establishing a controversy.”  The facts about smoking did not carry the day as Financial Times columnist, Tim Harford, reveals in his latest book. The tobacco industry managed to avoid litigation and regulation for decades thereafter.

In the world of hard sciences like chemistry and biology, even incontrovertible facts can be disputed and raise doubt. Finance or economics is not a hard science. There are no facts or immutable laws. And into that void of vagueness, half-truths can blossom. Investors beware.  

Exaggerated stock market claims

I can count on the fingers of about ten hands how many dubious claims I have seen from investment products and managers over the years. There are very few parts of the investment universe immune from it.  For example, Environmental, Social and Governance (ESG) is unquestionably one of the most powerful forces in investment markets at the moment.  A recent NYU paper found that the majority of more than 200 studies published since 2015 concluded that ESG boosted returns. These claims are disputed by Edhec-Risk Institute, a French academic think-tank and its analysis bears scrutiny. 

ESG investing 

The idea behind ESG investing is that we should invest our money into companies that behave well and take it out of companies that don’t. Doing this is effective because it changes companies’ cost of capital. The corollary to divestment campaigns that raise the cost of capital for controversial companies is an increase in return for investors willing to take the opposite side of the transaction. As money flows to “green” companies, their bonds and shares increase in price, and their cost of capital falls. By the same token, when you pay more for future cash flows (by discounting them at a lower cost of capital), that lowers your expected return, all else being equal. 

Expected returns do not always equal realised returns. This happens when the market is surprised, either by customers suddenly demanding more, or investors wanting to own more green investments. And the winds of regulatory change are clearly pushing in that direction. 

I think the current trend in ESG investing is important in dealing with the myriad challenges we face and is the right strategy for many clients. But a decision to invest shouldn’t be linked to claims of outperformance.

Dubious numbers and false claims fill our daily lives. It doesn’t mean that you can’t do well by doing good, but sometimes virtue may have to be its own reward.