Key Takeaways
- From the 1920s to the 1990s, the stock market returned more in January than in other months.
- This effect was also noticed in other asset classes and other markets.
- In recent years, the effect has not always worked, and in many years, investors have lost money in January.
Definition and Examples of the January Effect
In 1942, investment banker Sidney Wachtel noticed that stocks tended to go up in January more than in other months. Academics confirmed this theory over the years in U.S. stocks, other asset classes, and other markets.
Note
As the theory evolved, it was restated to show that smaller stocks would outperform large stocks. This is because smaller stocks have a less efficient market, so the forces causing stocks to rise in January would affect them more.
Some investors have long doubted the efficacy of the January Effect. Efficient market theorist Burton G. Malkiel suggested in 2003 that if the effect was real, investors would begin buying earlier in December to take advantage of it, causing the January Effect to move to a December Effect and eventually self-destruct.
Others suggest that long-term data pertaining to good January stock performance can be misleading, as it relies on outperformance seen many decades ago. For the decade ending in 2019, despite a bull run, January did not always yield positive returns for the stock markets.
How Does the January Effect Work?
When the January Effect did work, three possible causes were proposed.
Tax-Loss Theory
The tax-loss theory is considered as the simplest explanation for the January Effect. Many investors sell losing stocks during the last quarter of the tax year so that they’re able to shoehorn the loss into their tax returns for the year. This selling pressure drives prices down in December—then in January, they recover when investors start buying again. This theory was never completely convincing because January Effects have also been observed in markets where there are no capital gains taxes—meaning there was no artificial selling pressure in December.
Year-End Bonus Fuels Trading
The next possible reason for the effect is that many employees receive bonuses in January for the prior year, which may aid them to buy securities. This theory stems from the critique of the tax-loss theory. Researchers found that the January Effect existed in markets such as Japan that don’t allow losses to offset capital gains tax. Interestingly, they observed that the December-January time frame also coincided with workers receiving their semi-annual bonus.
The counterargument to this theory is that individual investors hold a very small part of the stock market directly. While any movement in stocks due to a concerted trend by individual investors is not impossible, it does seem unlikely in a market where institutional and high-frequency traders exist.
Portfolio Rebalancing
A third potential explanation for the January Effect is portfolio rebalancing, a common theory in the 1970s and 1980s when the January Effect was strongest. The theory stated that portfolio managers would “window dress” their portfolios by selling risky stocks in December so that they wouldn’t show up on the fund’s annual report. Then the managers would pile back into these smaller stocks in January. This theory is plausible because most studies have shown that smaller stocks (i.e., riskier stocks) have the highest returns in January.
There may still be some window dressing done by portfolio managers, but the types of small, risky stocks the funds didn’t want to admit to owning in the 1980s are now more popular. Innumerable modern funds advertise the fact that they invest in small and risky, high-growing stocks. Additionally, much more money is in ETFs today. Many ETFs report their holdings every single day—there is now a way to window dress at year-end if that is the case.
Another alternate portfolio rebalancing theory was put forward years ago when the January Effect was in full force. Portfolio managers would sell out of risky stocks once they earned a sufficient return for the year, then replace those stocks with low-risk bonds. Just like the other theory, portfolio managers would then pile into smaller stocks in January, driving the return.
This theory is also harmed by the fact that ETFs report their holdings daily. If you advertise your fund as a small-cap growth fund and investors see that you’re holding Treasury bonds in July, you’d not really be true to your investment objective.
What It Means for Individual Investors
In recent years, the January Effect has been inconsistent for U.S. stock markets. It’s possible the effect lives on in other asset classes or in less developed markets where the market is less efficient (as it once was in small U.S. stocks), but scholars report inconclusive findings.
Many seasonal factors may impact the stock markets, but it’s perhaps best not to solely rely on them while making investment decisions.
