The “October Effect”: Is October Really a Scary Month for Markets?

October has a branding problem.

Maybe it's Halloween. Maybe it's the changing seasons. Or maybe it's because some of the most terrifying moments in financial-market history happened to occur during the tenth month of the year. Whatever the reason, mention October to a longtime market participant and there's a good chance you'll hear the same warning: Watch out. October can be ugly.

And, to be fair, history has given investors plenty of reasons to be nervous.

The most famous example came in 1929. After years of speculation during the Roaring Twenties, the Dow Jones Industrial Average peaked on September 3, 1929, at 381.17. The selling intensified dramatically the following month, culminating in Black Monday on October 28, when the Dow plunged nearly 13% in a single session. If that wasn't painful enough, investors showed up the next morning for Black Tuesday and watched the market fall nearly another 12%. By mid-November, the Dow had lost almost half its value from the September peak, and the bear market that followed ultimately carried the index roughly 89% below its high by July 1932.

That's not exactly the kind of October investors want to find in their trick-or-treat bag.

Then came October 19, 1987. (insert dramatic doom audio.. Dun dun dun dun!!!) Black Monday.

In one trading session, the Dow Jones Industrial Average fell 508 points, or 22.6%. To this day, it remains the largest one-day percentage decline in the Dow's history. Put that into perspective for a moment. We live in a market where a 3% decline can have financial television rolling out the red graphics and interviewing anyone who happens to be standing near the New York Stock Exchange. Imagine turning on your screen and seeing the market down more than 22% in one day.

Suddenly that 3% pullback doesn't look so bad.

October has hosted other periods of extraordinary volatility as well, including the financial crisis of 2008, and those events have helped create what economists and market historians sometimes call the “October Effect”—the perception that stocks are unusually likely to decline or crash during October.

There's only one problem.

The data don't really support the reputation.

Historically, October hasn't even been the worst month for stocks. Using S&P 500 history, October has actually produced a positive average return over the long run. S&P Dow Jones Indices has calculated that the S&P 500 historically gained about 0.46% during October and finished the month higher roughly 57% of the time. By comparison, September has historically been the real troublemaker. Over the past 75 years, the S&P 500 has averaged approximately a 0.7% decline during September and has finished higher only about 44% of the time.

Apparently September has a better public-relations department.

So why does October get all the attention? Because investors remember dramatic events far more vividly than ordinary ones. Nobody remembers the October when the S&P 500 quietly gained 1.2% while they were picking out Halloween costumes. They remember Black Monday. They remember 1929. They remember 2008. Our brains naturally give greater weight to dramatic experiences, and a 22.6% single-day collapse tends to leave a slightly larger impression than a boring month of normal market activity.

Where October does deserve some respect is volatility. Historically, the month has produced an unusually large number of significant daily moves. Research going back to 1950 has shown that October has experienced more 1% daily moves in the S&P 500, both higher and lower, than any other month. That's an important distinction. Volatility doesn't automatically mean the market is going down. It means the market may move more aggressively in either direction.

And that brings us to the part I believe matters most for traders and investors today.

History is useful, but history is not a trading strategy.

I love historical market statistics. Anyone who has taken a class with me or watched my show knows, I'll happily dig through decades of data looking for patterns, probabilities, and tendencies. But there's a huge difference between understanding a historical tendency and assuming that tendency tells you what's going to happen next.

October doesn't wake up on the first trading day of the month, look at the calendar, and say, “Well, I guess it's time to crash.”

Markets move because of earnings, interest rates, monetary policy, economic growth, inflation, employment, liquidity, geopolitical events, positioning, valuation, investor psychology, and hundreds of other variables. The fact that the calendar says October doesn't suddenly override all of those forces.

That's where investors can get themselves into trouble with seasonality. If you convince yourself that October is going to be terrible simply because several historic crashes happened during October, you may start seeing bearish signals everywhere. Every red candle becomes confirmation. Every negative headline becomes evidence that “the crash” has begun. Before long, you're no longer trading the market in front of you; you're trading a story you've already decided is true.

That's dangerous.

The opposite can be equally dangerous. Historical averages showing that October has generally been positive don't mean investors should blindly buy stocks on October 1. An average is simply the mathematical result of many very different market environments. It doesn't know anything about today's valuations, interest rates, earnings, geopolitical risks, or economic conditions.

As traders, our job isn't to predict what October should do. Our job is to observe what the market is actually doing and manage risk accordingly.

That's why I believe seasonal statistics should be treated as one piece of information rather than a buy or sell signal. If October historically brings greater volatility, fantastic, be aware of it. Maybe that means reviewing position sizes, tightening up your risk-management process, making sure your stops are where they belong, and being mentally prepared for larger daily swings. What it shouldn't mean is liquidating your portfolio on September 30, hiding under your desk, and waiting for November.

After nearly three decades in the financial markets, one lesson continues to prove itself over and over again: price matters more than predictions.

Have a plan before you enter a trade. Know where you're wrong. Know how much you're willing to lose if you're wrong. Understand the economic and technical forces influencing the market, and then let price tell you whether your thesis is working.

October may indeed give us some fireworks. History tells us that's entirely possible. It could also turn out to be a fantastic month for equities, because history tells us that's possible too.

That's the beauty, and occasionally the frustration of financial markets.

History can help us understand what can happen.

It doesn't tell us what will happen.

So enjoy October. Watch the markets. Manage your risk. Stick to your trading plan. And if you're looking for something guaranteed to scare you this Halloween, forget the October Effect.

Just pull up one of your old trades from before you learned proper risk management.

Now that's scary.