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What Is January Effect?

UTC by Beatrice Mastropietro · 8 min read
What Is January Effect?
Photo: Unsplash

The January effect is a term that refers to an increase in market activity in January. The stock markets tend to rise significantly more immediately after New Year, with some people believing it’s because investors are rushing back into stocks for tax purposes. We will take a deep dive into everything you need to know about the January effect in this guide.

The January effect is a pattern of stock market activity that occurs near the turn of the calendar year. In particular, stocks that rank among the best performers over the previous 11 months of trading tend to show remarkable strength in their last two months, more so than those with less impressive past performances. The phenomenon has been observed and studied many times during the past century, yet it still does not have a perfect explanation or consensus.

There are numerous studies and theories on the possible causes of the January effect, but most revolve around two main ideas. They are seasonal tax-loss selling and investor behavior. On the one hand, skeptics believe that stocks that deliver high returns over the previous 11 months tend to show weakness in December as investors who made large profits during that time sell their holdings to lock those gains into the current tax year.

On the other hand, investors experience a heightened state of fear during the final days of December, which causes them to sell low-priced and underperforming stocks to enjoy an inflated number for net worth on paper by refreshing it at the beginning of the new year.

It does not take much research to discover the following: most of the highest percentage gains over 11 months do come in early January, and most of the largest drops in monthly comparison also come at that time. Thus, there is strong evidence showing a strong link between the January effect and investor behavior. In particular, investors seem to be heavily influenced by their emotions when trading around year-end.

January Effect Overview

The January effect is a seasonal anomaly in which the stock market experiences a rise, beginning right after Christmas and continuing through to the end of January. The month of January itself has been an outperforming one for equities since 1950. From 1950 to 2009, the average return for the S&P 500 during this period was 0.48%, trailing only November (which averaged 1.05%) among all months in that span. If you go back further in history, the performance in January is even more impressive. For example, from 1871 to 1938, it easily led all other months with an average gain of 2% over its nearest competitor, October. Even going back as far as 1901, it still had the second-best return, April. So what causes this January effect?

First of all, there are many different theories about why it happens. The most common ones include tax-loss harvesting by institutions, window dressing (also known as “performance chasing”), year-end flows, and simple mean reversion. It is possible that some or all of these factors play a role in causing the anomaly. Still, for now, we can say one thing with certainty: the January effect does not result from seasonal influences like cold weather or holiday cheer, as many sources are saying.

History of the January Effect

The phenomenon of the January effect has always been fascinating because it is counter-intuitive. The more people want to sell stocks, the more they should be worth! But for some reason, investors across the country collectively decide to wait until after new year’s day to sell their stocks. It probably started with a few early retirees selling their stock holdings just before year-end to lock in gains and pay any taxes due on those gains before going into retirement mode. Then other retirees followed suit, only selling just after New Year, and others started to follow. Then mutual funds also had to get in the game because their clients, who turned into net sellers during this period, decided not to sell rather than pay taxes on gains. The last hold-outs were the individual investors who didn’t want to give up any potential capital gains just before year-end, so they waited until after New Year’s day when everyone else was selling.

By 1960, people believed it became a self-fulfilling prophecy, and the effect was amplified precisely because it became well known. There are also legitimate reasons why stock prices are lower in January than any other month, but most of the decline is an artifact of psychology rather than economic conditions.

It is commonly believed that stock returns are lower during January than any other month due to taxes and the belief in an illiquid market. While tax explanations for this phenomenon have been discredited, the liquidity explanation remains unclear.

Reasons for the January Effect

Let us get to know what causes this phenomenon.

  • Exposure bias. Stocks that are not represented in the major indices are usually under-researched by analysts. Because of this, some investors use January as a chance to purchase these stocks before they are discovered. Brokers then recommend these stocks to their customers. This causes an increase in prices of under-researched small capitalization stocks during January.
  • Illiquid stocks. Stock prices tend to be erratic around certain days of the year, due to lack of market or investor activity on those dates. Because there is less demand for the stock on those dates, brokers may decide not to sell them due to low liquidity. As more Investors decide against purchasing these illiquid stocks, their price goes up, causing a January effect.
  • Seasonal patterns. Many investors buy stocks as long-term investments. However, many individuals also sell stocks to purchase other assets as the year comes to an end. This selling causes stock prices to drop in December and rise in January. This behavior often leads to a positive return for those who have invested in small-capitalization stocks during January.
  • Selling by institutions. Most institutional investors require traders to meet certain sales targets by the end of each quarter. If they fail to meet these targets, they may be fired from their job or demoted within the company, losing out on potential bonuses that are paid out at the end of each year if their trading results are deemed satisfactory. This may cause institutional investors to sell their stocks throughout December to meet these sales targets. Selling of this nature causes prices of small-capitalization stocks to go down during December and rise in January, causing an apparent January effect.
  • Seasoned stocks. Stocks that have been traded for a longer period of time tend to experience higher returns around the beginning or end of each month due to increased buying activity. Generally, the market tends to be more active at certain points during the day than others, with mid-day being a slow period where less trading takes place. Because many analysis models use closing prices when calculating price movement trends, stocks that experience large changes during this slower period will appear to rise or fall at a higher rate than normal.

Benefits of the January Effect

As the January effect takes place at the start of a new year, it can be a prime opportunity to purchase stocks that have been underperforming for months. This allows investors to purchase stocks near their 52-week lows and re-evaluate them later when they have increased in price.

In addition, many analysts choose to focus on January’s top performers during this month because it is easier for an investor to pinpoint opportunities found within a smaller group of companies/sectors who succeeded in January as opposed to evaluating those from an entire market. Furthermore, the term “January effect” has become so popular that studies may be skewed towards finding price patterns where none exist.

Another benefit includes reduced capital gains taxes for people invested in mutual funds. Mutual funds are required to distribute dividends and long-term capital gains to their shareholders at certain times during the year, usually December and April. However, because of the January effect, investors will experience a lower tax rate as they will be purchasing these investments when it’s nearly mid-January.

Yet another benefit includes higher expected returns because prices tend to bottom between December 28 and December 31. However, there is no guarantee that any company’s stock price will rise as frequently as it had in prior years due to increased competition from index funds.

The January effect can do nothing to help an already down-trending stock. If a negative event is occurring at the company, which began before December 31 of last year, it is unlikely that this trend will be reversed by January 22.

Conclusion

The January effect is a phenomenon in which stocks post significant gains in January. Some traders believe that the January effect is a reliable ‘calendar effect’ that can be used for trading opportunities. In other words, it provides a chance to purchase stocks at a low price and sell them after the January effect has taken place and increased their prices. Others may simply consider the January effect when otherwise looking to buy or sell stocks around that time of the year.

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FAQ

What is the January effect?

The January effect is the tendency for stock prices to rise in the first month following a year-end sell-off for tax purposes.

How does the January effect work?

The January effect works by investors rebalancing their portfolios in December and making an extra attempt to try and beat the market. 

Why does the January effect happen?

It is often attributed to investors reentering the market after selling off their holdings at year-end to avoid incurring additional tax liabilities.

Are there any benefits of the January effect?

There are many benefits of the January effect. Some of them include the fact that a mutual fund or an index fund will perform better since it has higher sale charges during the other months. Besides, as the January effect takes place at the start of a new year, it can be a prime opportunity to purchase stocks that have been underperforming for months. This allows investors to purchase stocks near their 52-week lows and re-evaluate them later when they have increased in price.

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