January Effect

Updated on 2023-08-29T11:54:31.791245Z

What is the January effect?

The January effect is a philosophy that states that stocks take a dip in the month of December and take a boost in the month of January. The phenomenon takes place because of the heavy selling at the end of the month and aggressive buying at the beginning of the year. At the end of the year, the investors tend to sell off their low performing assets and buy the same assets after a few weeks or days.

Summary

• The January effect is a philosophy that states that stocks take a dip in the month of December and take a boost in the month of January.
• At the end of the year, the investors tend to sell off their low performing assets and buy the same assets after a few weeks or days.
• Tax planning, window dressing by the mutual fund companies and the investor’s psychology drives the January effect.

Frequently Asked Questions (FAQs)

What factors drive the January effect?

Tax planning drives the January effect. Before the end of the year, the stocks are sold by the investors even if they are facing losses because they aim to avoid the capital gains taxes. Once the taxation period is over, the investors buy back their position in the market with the hope to make profits.

Taxes are calculated on the collective capital gains which are generally calculated from January 1 to December 31. The “collective” holds significance. An investor pays taxes on the total income.

An example would be helpful in understanding the same. An investor holds a position in company X, Y and Z. The investor sells the stocks of all the three companies which were giving a profit of $10,000, a profit of $5,000 and a loss of $7,000 respectively. Here, the taxable income would be $8,000. So, by selling the stocks before the year end, the investor can save tax on the $8,000 (the income). The position might be taken back by the investor in company Z, even it is showing losses because the investor might believe that the company will generate profit in the long run.

Despite the tax-loss harvesting, the January effect is driven by the investor’s psychology as well. Some investors have the belief that January is the appropriate month for investments or investments are also driven by the New Year’s resolution, that is, securing the future from the beginning of the year.

At the end of each year, the mutual fund managers sell off the low performing stocks and purchase the top performing stocks for their year-end reports’ sake only. This process is known as window dressing. The selling and buying procedure affect the large caps.

Research by D’Mello, Ferris, and Hwang (2003) indicated that stocks with heavy capital losses are sold off before the beginning of the new year and the stocks with heavy capital gains are sold at the beginning of a new year. The sell-off in the year end attracts a large number of buyers who are interested in investing at lower prices and these lower prices are not driven by the fundamental and technical factors. This results in an increase in the prices in the month of January.

What is the significance of the January effect?

Many studies have provided pieces of evidence, from the year 1904 to 1974, that the January effect is existing and the average return in January is five times more than the average return from the other calendar months. The smaller companies show the pattern significantly in comparison to the large companies. A study by Salomon Smith Barney projected that small caps were able to outperform the large caps in the year 1979 to 2002 by an average of 82 basis points only in the month of January and performed poorly in the rest of the months.

It would seem that it is the easiest way to make a profit in the stock market, however, it is not the case. In recent years, it has become difficult because the phenomenon is becoming less pronounced. There are numerous reasons due to which this phenomenon is not taking place anymore. Presently, the investors are saving their assets in tax sheltered accounts such as IRAs and 401(k)s. In effect, the need to sell the assets for the purpose of saving taxes is not required. Many traders and investors are anticipating the rise in January and the prices of the stock become adjusted before the time. As a result, the Santa Claus rally phenomenon has come into effect. It is the period of buying before the January effect. These trends are monitored by the investors; however, the analyst says that an investor should not rely on these phenomena for making an easy profit in short term.

What factors should be considered while preparing for the January effect?

It is crucial that the investor undertakes a fundamental analysis of the company before deciding upon the January spike. Fundamental analysis includes analysing the financial health of the company such as the growth potential, profit margins and revenues. It also includes market positioning, management and so on.

After taking into consideration these aspects, the investor will be able to comprehend price movement and swings, adding confidence in the decision regarding investment in the month of January.

Does the January effect really exist?

An inefficient market can be located by identifying calendar-based fluctuations. Calendar-based fluctuations occur when the investors are selling and buying the asset solely on the basis of the external concerns and not on the basis of the value of the underlying asset.

It has been argued by the modern market theorists that presently the market is too efficient for the January effect to occur and affect the trading. As few investors will be selling their positions in December, another group of investors will anticipate the same and take a long position in the market with the prediction that the value will increase in January.

The presence of the January effect is debated. The effect cannot be observed any longer like it used to happen in the mid-20^th century. However, few studies have presented pieces of evidence that the January effect affects the market to a certain extent. 

What is the January effect?

The January effect is a philosophy that states that stocks take a dip in the month of December and take a boost in the month of January. The phenomenon takes place because of the heavy selling at the end of the month and aggressive buying at the beginning of the year. At the end of the year, the investors tend to sell off their low performing assets and buy the same assets after a few weeks or days.

Summary

• The January effect is a philosophy that states that stocks take a dip in the month of December and take a boost in the month of January.
• At the end of the year, the investors tend to sell off their low performing assets and buy the same assets after a few weeks or days.
• Tax planning, window dressing by the mutual fund companies and the investor’s psychology drives the January effect.

Frequently Asked Questions (FAQs)

What factors drive the January effect?

Tax planning drives the January effect. Before the end of the year, the stocks are sold by the investors even if they are facing losses because they aim to avoid the capital gains taxes. Once the taxation period is over, the investors buy back their position in the market with the hope to make profits.

Taxes are calculated on the collective capital gains which are generally calculated from January 1 to December 31. The “collective” holds significance. An investor pays taxes on the total income.

An example would be helpful in understanding the same. An investor holds a position in company X, Y and Z. The investor sells the stocks of all the three companies which were giving a profit of $10,000, a profit of $5,000 and a loss of $7,000 respectively. Here, the taxable income would be $8,000. So, by selling the stocks before the year end, the investor can save tax on the $8,000 (the income). The position might be taken back by the investor in company Z, even it is showing losses because the investor might believe that the company will generate profit in the long run.

Despite the tax-loss harvesting, the January effect is driven by the investor’s psychology as well. Some investors have the belief that January is the appropriate month for investments or investments are also driven by the New Year’s resolution, that is, securing the future from the beginning of the year.

At the end of each year, the mutual fund managers sell off the low performing stocks and purchase the top performing stocks for their year-end reports’ sake only. This process is known as window dressing. The selling and buying procedure affect the large caps.

Research by D’Mello, Ferris, and Hwang (2003) indicated that stocks with heavy capital losses are sold off before the beginning of the new year and the stocks with heavy capital gains are sold at the beginning of a new year. The sell-off in the year end attracts a large number of buyers who are interested in investing at lower prices and these lower prices are not driven by the fundamental and technical factors. This results in an increase in the prices in the month of January.

What is the significance of the January effect?

Many studies have provided pieces of evidence, from the year 1904 to 1974, that the January effect is existing and the average return in January is five times more than the average return from the other calendar months. The smaller companies show the pattern significantly in comparison to the large companies. A study by Salomon Smith Barney projected that small caps were able to outperform the large caps in the year 1979 to 2002 by an average of 82 basis points only in the month of January and performed poorly in the rest of the months.

It would seem that it is the easiest way to make a profit in the stock market, however, it is not the case. In recent years, it has become difficult because the phenomenon is becoming less pronounced. There are numerous reasons due to which this phenomenon is not taking place anymore. Presently, the investors are saving their assets in tax sheltered accounts such as IRAs and 401(k)s. In effect, the need to sell the assets for the purpose of saving taxes is not required. Many traders and investors are anticipating the rise in January and the prices of the stock become adjusted before the time. As a result, the Santa Claus rally phenomenon has come into effect. It is the period of buying before the January effect. These trends are monitored by the investors; however, the analyst says that an investor should not rely on these phenomena for making an easy profit in short term.

What factors should be considered while preparing for the January effect?

It is crucial that the investor undertakes a fundamental analysis of the company before deciding upon the January spike. Fundamental analysis includes analysing the financial health of the company such as the growth potential, profit margins and revenues. It also includes market positioning, management and so on.

After taking into consideration these aspects, the investor will be able to comprehend price movement and swings, adding confidence in the decision regarding investment in the month of January.

Does the January effect really exist?

An inefficient market can be located by identifying calendar-based fluctuations. Calendar-based fluctuations occur when the investors are selling and buying the asset solely on the basis of the external concerns and not on the basis of the value of the underlying asset.

It has been argued by the modern market theorists that presently the market is too efficient for the January effect to occur and affect the trading. As few investors will be selling their positions in December, another group of investors will anticipate the same and take a long position in the market with the prediction that the value will increase in January.

The presence of the January effect is debated. The effect cannot be observed any longer like it used to happen in the mid-20^th century. However, few studies have presented pieces of evidence that the January effect affects the market to a certain extent.