Definition and Examples of the January Effect
The January effect refers to the seasonal increase in stock prices during the month of January.
From the 1920s through the 1990s, financial markets tended to yield more profits in January compared to other months. This effect has also been observed in other asset classes and markets. In recent years, the effect has not always held, and often, investors have lost money in January.
In 1942, investment banker Sidney Wachtel noted that stocks tend to rise in January more than in other months. Academics have confirmed this theory over the years in U.S. stocks, other asset classes, and markets.
As the theory evolved, it was reformulated to suggest that smaller stocks would outperform larger ones. This is because smaller stocks have a less efficient market, thus the forces driving stock prices up in January will have a greater impact on them.
Some investors have long questioned the effectiveness of the January effect. Efficient market theorist Burton G. Malkiel suggested in 2003 that if the effect were real, investors would begin buying earlier in December to take advantage of it, leading to a shift of the January effect into December, ultimately undermining itself.
Others point out that long-term data regarding good stock performance in January may be misleading, as it relies on the exceptional performance seen many decades ago. Despite the rise in the market during the decade ending in 2019, January has not always delivered positive returns for stock markets.
How does the January Effect Work?
When the January effect is in play, three potential reasons have been suggested:
Tax-loss harvesting theory: The tax-loss harvesting theory is the simplest explanation for the January effect. Many investors sell losing stocks during the last quarter of the tax year so they can include the loss in their tax returns for the year. This selling pressure leads to lower prices in December, then in January, prices recover as investors begin buying again. This explanation has not been entirely convincing because the January effect has also been observed in markets that do not impose taxes on capital gains, indicating that there has not been artificial selling pressure in December.
Year-end trading boost: The next potential reason for the effect is that many employees receive bonuses in January for the previous year, which may help them to purchase securities. This theory stems from criticism of the tax-loss harvesting theory. Researchers have found that the January effect exists in markets like Japan, which do not allow losses to offset capital gains taxes. Interestingly, the period from December to January also coincides with when workers receive their semi-annual bonuses.
Portfolio rebalancing: A third possible explanation for the January effect is portfolio rebalancing, a theory that was popular in the 1970s and 1980s when the January effect was at its strongest. The theory states that portfolio managers “window dress” their portfolios by selling high-risk stocks in December so they do not appear in the annual fund report. Then, managers return to buy these smaller stocks in January. This theory is plausible because most studies have shown that smaller stocks (i.e., the riskiest stocks) have the highest returns in January. There may still be some window dressing taking place by portfolio managers, but the types of small, risky stocks that funds were reluctant to admit owning in the 1980s have now become more mainstream. Additionally, there is now more money in ETF funds. Many ETFs report their holdings daily, and there is now a way to window dress at year-end if that is the case.
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This theory has also been challenged by the existence of ETFs that report their holdings daily. If you announce your fund as a small-cap growth fund and investors see you holding treasury bonds in July, it won’t really align with your investment objective.
What does this mean for individual investors?
In recent years, the January effect has been inconsistent for U.S. stock markets. The effect may still exist in other asset classes or in less developed markets where the market is less efficient (as was the case with U.S. small-cap stocks in the past), but researchers are presenting inconclusive results.
Several seasonal factors may influence stock markets, but it is best not to rely solely on them when making investment decisions.
Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
National Association of Retirement Plan Advisors. “How Has the January Effect Impacted the Average 401(k)?” Accessed October 9, 2021.
Burton G. Malkiel. “The Efficient Market Hypothesis and Its Critics.” Journal of Economic Perspectives. Accessed October 9, 2021.
Schroders Investment Management. “Does the January Effect Really Exist?” Accessed October 9, 2021.
Richard H. Thaler. “Anomalies: The January Effect.” Journal of Economic Perspectives. Accessed October 9, 2021.
Warrington College of Business, University of Florida. “Individual Investor Behavior in Buying and Selling Securities at Year-End.” Accessed October 9, 2021.
Jay R. Ritter and Naveen Chopra. “Portfolio Rebalancing and the Year-End Effect.” Journal of Finance. Accessed October 9, 2021.
Source: https://www.thebalancemoney.com/january-effect-5205151
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