What is the October effect?

There is a theory known as the October effect, where stock prices fall in October. Since most statistics contradict the hypothesis, it is thought to be more of a psychological event than a real event. October is a month that has historically seen some significant market crashes, which may make some investors concerned.

Along with the Santa Claus rally and the alleged September effect, it is one of several calendar irregularities.

 

History of the Stock Market in October

In actuality, October’s 100-year stock market history has been largely bullish. The notion that equities decline in October is primarily the result of four events. These include Black Monday in 1987, the 1929 stock market crash, the Panic of 1907, and the falls associated with the 2008 financial crisis.

Black Monday, on October 19, 1987, remains one of the most dramatic days in stock market history. The Dow Jones Industrial Average plummeted by a staggering 22.6% in just one day, erasing over $1 trillion in value. Fueled by program trading, overvaluation, and liquidity issues, this crash sent panic rippling through global markets. While recovery came swiftly, the event underscored the psychological pressures investors face.

Just over half a century earlier, the 1929 Stock Market Crash marked the onset of the Great Depression. The turmoil began in late October, culminating on Black Thursday, October 24, when panic selling led to a nearly 30% drop in the Dow. Rampant speculation and excessive leverage were significant contributors, resulting in severe repercussions that reshaped financial regulations to prevent future crises.

 

The Panic of 1907 further illustrates the October effect, peaking on October 22. This crisis revealed vulnerabilities in the unregulated banking system and triggered widespread fear through liquidity shortages and bank runs. The turmoil ultimately led to the creation of the Federal Reserve System in 1913, aimed at stabilising the financial landscape.

 

Finally, the 2008 Financial Crisis, which gained momentum in October was triggered by the collapse of the housing market, resulting in unprecedented volatility in the stock market. The fallout not only reshaped regulations but also highlighted the psychological factors that drive investor behaviour during turbulent times.

 

The psychology behind the October Effect

Every stock market crash is influenced by human psychology, which typically exacerbates the losses. Herd instinct and loss aversion are two prevalent behaviours which occur during a crash.

 

Herd instinct

The urge to follow in the actions of the majority is known as the herd instinct. When markets are strong, it encourages investors to purchase stocks, and when they are not, they sell. The market as a whole, certain industries, or individual stocks may all become overvalued or undervalued as a result of this behaviour. More specifically, following the herd tends to result in high buys and low sales, which is counterproductive.

Loss Aversion

Loss aversion is a tendency to experience losses more intensely than upsides. For example, the pain of losing 10% of the value of your portfolio is typically more enduring than the excitement of making 10%.

Investors suffering from loss aversion may resort to drastic, occasionally nonsensical means to safeguard their wealth. For instance, a lot of investors sell their investments when they lose value. However, liquidation does not prevent, but rather produces, a loss. Waiting for that recovery is typically a preferable course of action, as every stock market crisis in history has ended in a rebound. However, investors are repeatedly unable to resist the temptation to sell their shares due to a fear of suffering even larger losses.

 

Financial advisors play a crucial role by providing objective guidance and encouraging clients to make informed decisions based on research and personal financial goals rather than emotional reactions to market trends. With the support of financial advisors, education about the dangers of following the herd and the psychological biases that can lead to bad decision-making can help you have a long-term perspective when it comes to achieving your goals.

 

Do we still see the October Effect?

Yardeni Research investigated the October effect by examining monthly S&P 500 performance from 1928 to 2024. In short, the idea that equities lose value in October is an oversimplification of the stock market. While dips have occurred in October, it is more normal to see stock prices climb throughout the month—albeit with some volatility.

 

What about other months?

Since 1928, three months of the year have seen average decreases in the stock market, according to data from Yardeni Research. February, May, and September.

October’s performance is the lowest among the months with average gains. July, April, and December have the highest historical averages. Their respective gains are 1.70%, 1.32%, and 1.31%.
It is noteworthy that the exceptional strength of July contradicts another calendar-based investing theory known as “Sell in May and go away”. The statement alludes to the false notion that stocks consistently perform worse over the summer.

In the face of market noise and psychological pressures, financial advisors provide invaluable support by offering guidance and a complete investment plan to achieve long-term goals. Financial advisors in Hong Kong can help investors stay focused on long-term goals, mitigate emotional decision-making, and navigate volatility. If you are still apprehensive, speak to your advisor and make sure your holdings align with your risk tolerance. After that, There’s nothing else to do except maintain composure and adhere to your financial plan.