What is the September Effect?

As summer winds down and fall approaches, investors start paying attention to an intriguing pattern in the stock market: Stocks have historically performed worse in September than in other months. This phenomenon, dubbed the “September Effect,” leaves many wondering why this drop-off happened and whether should I change my investing approach this month. 

Read on to understand what drives the September Effect, whether it continues to occur today, and tips for investing during September and volatile markets.

What exactly is the September effect?

The September Effect refers to the observation that stock market returns in September tend to be weaker than the rest of the year. According to data going back to the US in 1928, the S&P 500 index averaged declines in September. 

While September is not always the single worst-performing month of the year for stocks, it has averaged negative returns over this lengthy period. The effect violates the principle of market efficiency, which assumes asset prices quickly incorporate all available information. However, the September Effect does not completely override broader market forces.

Digging into potential explanations

Researchers have proposed the potential explanations for the negative September Effect over the decades:

1. Investors sell positions to realise losses for tax purposes. By locking in losses in September, investors can offset capital gains taxes on profitable investments. This selling pressure drives down prices.

2. Money managers sell underperforming positions at quarter end. With the third fiscal quarter wrapping up, fund managers closing their books may sell lagging stocks, contributing to the slump.

3. People pull money from the market for September expenses. Investors withdraw cash from the market to cover added costs like tuition payments and school supplies for their children going back to school. This also creates selling pressure.

4. Traders anticipate and act on the September decline. As belief in the September Effect spreads, it may become a self-fulfilling prophecy. Investors sell stocks in advance, fueling an expected September drop.

While logically plausible, most economists remain skeptical of these explanations. They argue that savvy traders would likely sniff out and exploit any predictable market drop, trading against it until prices normalised. However, the persistence of below-average September returns suggests either an underlying cause or traders failing to capitalise on the pattern.

Putting the September effect in context

Before pulling money out of stocks every August, it’s important to put the September Effect in the context of the broader market. A few key statistics suggest taking a measured approach:

• The effect depends heavily on the timeframe. While September returns were quite poor over the past century, an investor who only looked at data back to 2014 would draw the opposite conclusion – September had above-average returns in recent years.

• On closer analysis, the gap between September and other months narrows. Over 1928-2021, the S&P 500 averaged a 1.04% drop in September – but only mildly below the average monthly return of 1.07% across all months.  

• Economists debate whether predictability exists at all. Some analyses spanning hundreds of years show that September returns are statistically in line with other months. The seeming pattern may result from randomness and chance over long periods.

In statistical terms, September’s underperformance is modest at best and more perceived than real. It does not support making dramatic portfolio shifts based on the calendar.

But even if not predictable, September brings volatility 

Even if September returns may not markedly lag other months, it does tend to be more volatile historically. This aligns with the theory that investors return from summer holidays and readjust positions, catalysing more severe price swings.

The bottom line is that while September’s weakness seems tied more to chance than a definite downward force, the month does tend to experience more pronounced ups and downs. For long-term investors, reacting to this short-term turbulence rarely pays off. However, being aware of these patterns can help set expectations.  

Tips for investing in September and volatile markets

For investors wondering if they should take any special precautions in September, here are a few tips:

• Maintain diversification and rebalance if needed. Ensuring an appropriate mix of asset classes and markets insulates you from the peculiarities of any single area. Revisit your target allocations and rebalance to get percentages back in line if needed.

• Tune out short-term noise. The September Effect – even if real – applies over a single month. Short-term movements have little relevance to disciplined long-term investors sticking to their strategy. Try to ignore market swings measured in days or weeks rather than years.

• Consider tax-loss harvesting if suitable. Taxable investors can purposely realise portfolio losses to offset realised capital gains, lowering their tax liability. This technique – tax-loss harvesting – could align well with any September decline. Work with a tax specialist to employ this appropriately and legally. 

In essence, September brings little reason for concern for diversified long-term investors. Maintain discipline, avoid irrational reactions, and take advantage of short-term downs and ups that may provide opportunities.

How does September compare to October in the stock market?

If September historically suffers weak returns, October earns a very different reputation – as potentially the best month for stocks. October returns have topped other months by an even wider margin than September has lagged. 

Several epic stock market crashes occurred in October – including 1929’s multi-day crash, signalling the start of the Great Depression. Major one-day plunges like “Black Monday” in 1987 also struck in October. So, considerable volatility comes alongside October’s higher returns.

This conflicting combination of strong average gains and turbulence leads to the “October Effect.” Explanations for October’s divergence mirror September theories – investors buy in anticipation of year-end rallies, managers window dress holdings before publishing statements showing quarter-end positions, etc.

However, just as the September Effect may arise from randomness, October’s place as the stock market’s best month could also stem from chance over the very long term. So again, reacting emotionally or hastily making major buy-sell decisions tied to the calendar has risks.

Key takeaways – what can we learn from September and October effects?

In the end, compelling evidence does not support the September Effect as a lasting rule of thumb for investors to follow. Instead, view it as an intriguing pattern that may or may not persist into the future.

Similarly, October’s banner status as the strongest month for equities comes with plenty of caveats. Ultimately, major investing decisions depend on your risk tolerance, goals, and time horizon rather than the time of year. 

However, understanding cycles like the September and October Effects can help you set realistic expectations. Periods like September and October do feature higher volatility as investors reassess positions. So anticipate turbulence, but don’t let it blow you dramatically off course.

Conclusion

The September Effect is a term used to describe a trend where the stock market performs weaker than usual during September. This trend has been observed in the past, but recently, it has become less reliable. Many experts now question whether it’s a good idea to base investment decisions on September alone. Instead, it’s better to make investment decisions based on research, your risk tolerance, and your investment timeline without worrying about the month of the year.

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