Lisa Kramer is a professor of finance at the University of Toronto.
Have markets got you down this fall?
While you may well know that gloomy financial markets can depress your mood, it turns out your mood can also influence markets.
In the autumn and winter seasons, when daylight is relatively scarce, a fraction of the population suffers from serious depression known as seasonal affective disorder, or SAD. Most of the rest of us also experience dampening of our moods, however the effects tend to be milder and well below the threshold for clinical depression. Importantly, despondent moods – whether mild or severe – tend to be accompanied by reduced willingness to take risks, including financial risks.
With so much of the population seasonally aligned in our moods, and consequently aligned in our reduced appetite for risky investments, market wobbles become more likely at this time of year.
Markets can suffer from blues, too, if you will.
Essentially, when bad economic news or heightened risks emerge in the autumn months, the repercussions in markets tend to be more pronounced than if the same information emerged in the spring, when both daylight and moods are rebounding. The end result is that many of the most catastrophic and memorable market meltdowns have taken place in the fall.
I explored these ideas formally in a series of peer-reviewed articles I wrote with several collaborators, primarily Mark Kamstra of York University and Maurice Levi of the University of British Columbia. We found seasonal cycles related to winter blues in a wide range of stock markets around the world. The further a country is located from the equator, the more daylight varies through the year, and, we discovered, the larger are the seasonal fluctuations in that country’s stock returns.
The Swedish stock market, for instance, has a bigger seasonal cycle related to human mood than markets in Canada. And just as the seasons in the Southern Hemisphere lag those in the Northern Hemisphere by six months (who wouldn’t love to be enjoying spring in Australia right now?), markets in the Southern Hemisphere also exhibit these seasonal stock return cycles six months out of phase relative to the north.
People willing to hold risky securities through the fall and winter seasons are, on average, rewarded for their courage. The risk premium earned on equities has been much higher, historically, during the fall and winter months than during the spring and summer.
Certainly it’s reasonable to wonder whether there might be some “rational” explanation for these market-wide effects. One skeptic noted that he would be convinced that seasonal moods are connected to financial market seasonality only if we ruled out “every possible alternative." That could take some time! In our research, we have carefully explored many dozens of plausible alternative hypotheses, and the notion that investor risk preferences vary seasonally is the only explanation consistent with the observed patterns in asset returns.
Additionally, we have conducted research showing that the patterns that drive stock-market return seasonality also drive other important financial quantities.
For instance, when risk appetite wanes in autumn and stock markets retract, investors gravitate toward the safest end of the risk spectrum, leading to a closely related seasonal pattern in the safest class of securities available, U.S. Treasury bonds. When risky equity returns are seasonally high, the safest bond returns are seasonally low, and vice versa. The annual cycle in Treasuries is much smaller in amplitude than that in equities, but it is still economically and statistically significant.
Furthermore, in work with Russell Wermers of the University of Maryland, my co-authors and I showed that contributions in and out of mutual funds vary over the course of the year in a manner consistent with these seasonal fluctuations in risk preferences. In the fall, when many investors are shunning risk, they tend to be directing their dollars toward relatively safe mutual funds, and then in the spring, when investors’ taste for risk rebounds, capital flows lean toward riskier mutual funds.
The upshot from this set of findings is decidedly not for investors to adjust their portfolio holdings seasonally. To the contrary, most investors are best off remaining true to a static investment strategy year-round. This is in part because the equity premium is always positive (which means that on average the return on holding stocks exceeds that on holding government bonds, year-round), and in part because market timing is not for the faint of heart.
Overall, the connection between emotions and financial markets highlights the fact that, for typical investors, it is unwise to make important financial decisions during times of personal upheaval. One ought to develop investment plans when moods are level and with awareness that risk appetites can vary with the seasons.
Such plans will not prevent winter blues in people or markets, but they will help in navigating the course to brighter days.