The October Effect: What It Is And How It Is Believed To Impact The Stock Market

Investors are not worried about ghosts and goblins this Halloween season. They’re worried about the “October Effect” and the spooky effect it can have on stock prices. Intrigued? Read on to find out what the October Effect is and whether you should be preparing for a portfolio scare.

What Is The October Effect?

The October Effect is a theory that stock prices decline in October. One basis for this belief is that nine of history’s 20 largest single-day percentage declines in the Dow Jones Industrial Average (DJIA) happened in the Halloween month.

Beyond that data point, however, research suggests the October Effect on stocks is superstition. Analysis by Yardeni Research indicates that since 1928, the S&P 500 has gained value in October more times than it has declined. And, averaging out October performance over the past 96 years shows a slight gain.

Although the numbers do not show stock price declines in October, there is evidence of high volatility. In an interview with Money, CFRA Research’s Chief Investment Strategist Sam Stovall said October is 35% more volatile than the average over the rest of the year.

History Of Stock Market Crashes In October

Four events are largely responsible for the belief that stocks dip in October. They are the Panic of 1907, the Stock Market Crash of 1929, Black Monday in 1987 and the declines related to the 2008 Financial Crisis.

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The Panic of 1907

In October 1907, while the U.S. was in recession, two speculators attempted to gain an influential level of control over the stock of a copper mining company. When the attempt failed, U.S. depositors began withdrawing funds from banks and trust companies associated with those speculators.

At the time, trust companies operated alongside banks in the financial system. These institutions held deposits and provided liquidity for stock trading but were not part of the central banking system. When Knickerbocker Trust faced a liquidity shortfall due to excessive withdrawals, the New York Clearing House initially denied support to conserve resources for member institutions. Consumer panic intensified and withdrawals increased, prompting a liquidity shortage in the stock market. J.P. Morgan and a group of bankers stepped in with $23 million to keep the NYSE open and operating.

The Stock Market Crash Of 1929

The historic crash of 1929 followed a period of economic expansion earlier in the 1920s. That expansion fostered optimism, which in turn encouraged speculation and trading on margin. Unfortunately, the good times would end. Production declines, rising unemployment, high debt and low wages set the stage for an overvalued financial market that needed a steep correction.

Stock prices began falling in early October. Investor fear rose and the market went into a tailspin near month’s end. Billions of shares were traded so quickly that tickers could not keep pace. The market lost 12.8% on October 28 and another 12% on October 29. The crash was followed by the Great Depression, which lasted for a decade.

Black Monday 1987

On October 19, 1987, the DJIA fell 22.6%. It was the second-largest single-day crash in stock market history. Contributing factors included:

1. High stock market growth earlier in the year, partly fueled by international investors
2. A growing U.S. trade deficit that weakened the dollar
3. The popularity of portfolio insurance: These contracts use options and derivatives to cap losses. Quickly falling stock prices triggered liquidations, which escalated the market dive.
4. Differences in settlement timing across the stock, options and futures markets led to negative trading account balances that, in turn, triggered more liquidations

The week before Black Monday, the U.S. financial markets softened, which stoked international panic over the weekend. Stock markets in Asia and New Zealand crashed before trading opened in the U.S. on Monday. The DJIA then fell immediately at the opening bell. Declines snowballed, fueled in part by automated liquidations.

Most of the losses incurred on Black Monday were recouped within days, and the markets fully recovered to set new highs within two years.

2008 Financial Crisis

On October 9, 2008, the DJIA fell nearly 679 points, shedding more than 7% of its value. Six days later, the index lost 733 points, declining nearly 8%.

Earlier that year, Bear Stearns and IndyMac collapsed, the U.S. Treasury took over Freddie Mac, Lehman Brothers declared bankruptcy and the U.S. government bailed out insurance company AIG. The failures were linked to the collapse of the housing market, which had bubbled due to lax lending standards and low interest rates. The Great Recession followed. The DJIA did not set new highs again until 2013.

Key Psychological Triggers

Human psychology contributes to every stock market crash, usually to extend the severity of the losses. Two common behaviors at work are loss aversion and herd instinct.

Loss Aversion

Loss aversion is a tendency to feel losses more deeply than gains. The sting of losing 10% in your portfolio’s value, for example, is usually more memorable than the buzz of gaining 10%.

Loss aversion can prompt investors to take extreme, sometimes illogical measures to protect their wealth. As stocks lose value, for example, many investors liquidate. The liquidation, however, does not prevent a loss—it creates one. Given that every stock market crash in history has reversed, waiting for that reversal is usually the better approach. But time and time again, investors cannot resist the urge to sell their holdings because they fear greater losses.

Herd Instinct

Herd instinct is the compulsion to mimic the behaviors of the majority. It drives investors to buy growth stocks when markets are strong and sell when markets are weak. This behavior can cause individual stocks, industries or the entire market to become overvalued or undervalued. On a more granular level, following the masses often leads to buying high and selling low, which works directly against the pursuit of investment gains.

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Is The October Effect Still Real In Modern Times?

Yardeni Research has addressed the October Effect with an analysis of monthly S&P 500 performance between 1928 and 2024. Key conclusions from that analysis are:

1. The S&P 500 gained value in October 56 times and lost value 40 times.
2. On average, the S&P 500 grew 0.52% in October. That equates to annualized growth of 6.2%.
3. When the S&P 500 rose in October, the average gain was 4.2%. When the index declined, the average loss was 4.6%.

In short, the theory that stocks lose value in October is an oversimplification of financial market behavior. While major crashes have occurred in October, the more common experience is that stock prices rise throughout the month—albeit with a tendency towards volatility.

Common Misconceptions About The October Effect

One common misconception about the October Effect is that stocks always decline in October. They do not.

It is important to recognize that any lasting market correction or volatility is usually linked to a chain of events that began months or years earlier. The Panic of 1907 had a shorter runway but also led to protective financial reforms, including the creation of the U.S. Federal Reserve System.

In the modern era, major market declines should deliver warning signs well in advance. This does not mean crashes are preventable, of course. The human tendencies of loss aversion and herd instinct alongside an increasingly interconnected and complex global financial ecosystem will always produce cycles of optimism and pessimism. Optimism
OP
fuels overvaluation, which inevitably creates the possibility for corrections.

October Versus Other Volatile Months

According to the Yardeni Research data, three months of the year have averaged stock market declines since 1928. They are February, May and September.

Compared to the months that averaged gains, October’s performance is the lowest. March follows with an average gain of 0.60% and August shows an average gain of 0.64%.

The months with the highest historical averages are July, April and December. They show gains of 1.70%, 1.32% and 1.31%, respectively. Note that July’s historic strength defies another calendar-based investing theory referred to as “Sell in May and go away.” The phrase refers to the unfounded belief that stocks routinely underperform in the summer months.

How To Handle Stock Market Fear

Fear can push even the savviest of investors to make regrettable decisions. For that reason, it is wise to have a plan for managing emotions when the market turns sour. You can take proactive and reactive measures here. Proactively, you might rethink and reaffirm your investment strategy. And reactively, you can adopt practical habits to keep your head level.

First, decide how much risk you can handle and adjust your portfolio accordingly. For stock ideas, see our list of best stocks of 2024. If you have never experienced a big market correction, be conservative in your self-reflection. The practical reality of a 30% wealth decline is more distressing than you might expect.

Next, think through your plan for bear markets. Unless you are trading heavily, the simplest and most reliable approach is to do nothing. Stay in the market, wait for the correction to run its course and be ready for recovery gains on the other side.

Finally, plan on managing your stress level when the inevitable correction appears. You might avoid reading financial headlines and temporarily ban yourself from logging into your portfolio account, for example.

Bottom Line

Some investors believe stocks lose value in October, but the theory is not supported by data. What the data does show is the potential for higher volatility in fall’s first full month. Now is a good time to verify your holdings align with your risk tolerance. After that, there’s nothing more to do but stay calm and stick to your strategy.

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