Are Your Stocks Sending Out a May-Day?

Many investors like simple market rules of thumb. So when market pundits not only advise you to "sell in May and go away," but can also point to the strategy's predictive power over the past several years, you might be tempted to obey them. Just to try to avoid the same carnage that you and others suffered in 2008.

Before you decide seasonal investing is right for you, it pays to take a closer look at exactly how well it has done. Although the "Sell in May" rule has worked pretty well recently, it also has some pitfalls for the unwary.

Thinking broadly
If you try to apply the "Sell in May" rule to the overall market, the past three years would have brought you reasonable success. Consider how the S&P 500 has performed since May 2006:

Source: Yahoo! Finance.

On its surface, that's not such a bad track record. Selling last May avoided the worst of the market's big drop. Over those three years, if you had invested only during the "desirable" November to April period, you would have lost about 15% of your money, versus around 23% for the May to October season.

Over longer periods of time, summer seasonality has some theoretical backing. One research study looked at a slightly different rule, going all the way back to 1950. It found that skipping the summer months would give you 50 times as much money as investing only from May to September.

May selling and stock picking
For those who invest in individual stocks, one interesting exercise is to drill down and see how many stocks behaved in perfect accordance with the rule. A quick stock screen of large-cap stocks within the Russell 1000 Index came up with just 21 stocks that rose every winter and spring, and dropped every summer and fall, including the following:

Source: Capital IQ, a division of Standard and Poor's. Averages are for each of three six-month periods from May 2006 to present. Returns through April 27.

Of course, with 21 stocks out of roughly 1,000 that always followed the rule, that leaves plenty of stocks that didn't. And while some of these stocks undoubtedly lost less during the cold months, you still can't be sure the stock you pick will.

A sure thing
Of course, no indicator like this works 100% of the time. But if you decide to follow a seasonal investing program like this, there are a few things about which you can be absolutely certain:

• If you're buying and selling stocks every six months, all of your gains will get taxed at higher short-term rates. You'll never hold your shares long enough to qualify for lower long-term capital gains rates -- which can be as low as 0% in some cases -- since you'd have to hang on for over a year.
• You'll also incur a full set of commission costs twice a year. If you're using a low-cost discount broker, that's not nearly as big a deal as it used to be. But still, it's an incremental cost that buy-and-hold investors don't have to deal with.

With two strikes already against you, you have to be extremely confident of success to justifying taking a chance by following a seasonal strategy.

The better way
Rules of thumb may be simple, but the better way to approach your investing is with a methodical approach you can follow all the time. If you identify good reasons why you expect your stocks to lose value, then selling them makes all the sense in the world. And if a stock makes it through its challenges -- or sees its price drop to more attractive levels -- then buying it back can often bring you a profit.

In all likelihood, though, those events won't match up perfectly to a particular day on a calendar. By giving yourself the flexibility to go beyond a simple rule and instead focus on the actual fundamentals of a given company, you can make the best buy and sell decisions on a stock -- while also potentially keeping some of the tax benefits of long-term investing.

More on smart stock investing:

• Do you own the greatest company in the history of the world?
• These stocks should be part of your portfolio.
• The biggest mistake Warren Buffett ever made.