Does avoiding the summer really make a difference for traders?

Financial writers and commentators use the phrase “the summer doldrums” every year to describe the time period between the beginning of summer in North America and Labor Day in the U.S. (July – August). Supposedly this period of time is associated with low volume and poor performance as many traders are away on vacation. This statement implies a “likelihood” or probability that doesn’t really exist and it is a fairly benign example of an account killing misconception about how the markets really work.

Video Analysis: The Truth Behind the Summer Doldrums

In the video accompanying this article I will look at the actual returns of the summer doldrums over different periods and you will see that profitability or losses appear much more randomly than most writers and analysts imply.

In fact, depending on when you take your sample set, you can find just about any period of time that has been profitable or unprofitable.

This is an example of investors trying to assume that market returns are normally distributed. A normal distribution of data is a lot like the bell curve used to grade students in college.

Most students will score a C-grade which is the average and is shown as the tall middle portion of the bell and fewer students will fail or get A-grades on the tails of the bell-curve. The bell curve can be used to visualize many kinds of data sets but not the financial markets.

The financial markets have more unusual readings (successes and crashes) than you would normally expect in a bell curve. The tails of the curve are very fat. Statisticians call this behavior “kurtosis.”

Because the tails are so fat they make normal probability analysis erroneous. Traders have on many occasions underestimated the impact of kurtosis and it has created big problems.

For example, Myron Scholes, a Nobel prize winning economist, started a hedge fund in the 90’s based on his “ability” to use statistics to analyze the markets. The financial models used by the fund significantly underestimated the impact of kurtosis and as a result the fund spiraled out of control and the Federal Reserve had to step in with a $3.6 billion bailout to head off disaster.

Does this sound similar to the events of 2007-2009? It should because the analysts at Lehman, S&P and Moodys (among many others) all made the exact same mistake.

The markets are inherently unpredictable. Anticipating the summer doldrums is as useless as relying exclusively on back-testing data to make decisions about the future.

This is an important concept to keep in mind as you evaluate trading strategies, market-timing techniques, fund managers, newsletters or trading system designers. In most cases these kinds of analysts do not understand market risk and kurtosis and are misrepresenting it to you.

Investing in the market is much more about managing risk and being flexible today than analyzing the past. Understand what tools you have available and maximize your control over those things you can influence such as costs and diversification. Don’t be one of those investors that chooses to ignore the lessons learned by Nobel prize winners and multinational banks that came before.

Image courtesy Marcus Hansson.