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It has been argued whether the financial markets are efficient or not for years. In short, an efficient financial market is where prices always fully reflect available information. However, some empirical results show that anomalies that violate market efficiency may occur.

In this article, I intent to concentrate on a famous market anomaly: The January Effect. Here is how Wikipedia defines it:

The January Effect is a seasonal anomaly in the financial market where securities' prices increase in the month of January more than in any other month. This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases.

The empirical work of Jay R. Ritter finds that the ratio of stock purchases to sales by individual investors displays a seasonal pattern, with individuals having a below-normal buy/sell ratio in late December and above-normal ration in early January. Small stocks are typically sold by individual investors in December -often to realize capital losses- and then bought back in January. Jay R. Ritter documented that small-cap securities often have had higher rates of return than large-cap stocks in the January months in the 20th Century. As a result, theoretically, buying and selling behavior of individual investors at the turn of the year creates a great arbitrage opportunity to profit.

So I dissect the performance of the small-cap Russell 2000 Index (RUT) versus the large-cap Russell 1000 Index (RUI) through all Januaries between 1993 and 2000, to see that most of the "January Effect" actually occurred within the first month of the year.

(click to enlarge)(Source: Yahoo Finance)

(Source: Yahoo Finance)

Unfortunately only 10 of 21 observations support the January effect. In other words, the theory is not dead but not strong enough to become an investment thesis even if Russell 2000 Index (RUT) had outperformed Russell 1000 Index (RUI) for the last two years.

So how about iShares Russell micro-cap index? Pietranico, Paul-Charles and Mark W. Riepe have a great work here. According to the results, the stocks in the 10th decile (with very small capitalizations) outperformed the 1st decile (very-large-capitalization) stocks in 70 of the 77 Januaries from 1926 to 2002 (see the graph below).

Micro-cap Performance

From 1926 through 2002, the smallest 10% of all stocks (or "10th decile") beat the 1st decile stocks by an average of 9.35 percentage points in the month of January.

The Bottom Line

The January Effect is debatable point and profiting by using it is not possible every time. Still, if you contemplate about building an investment strategy with behavioral tools, the January Effect could seem like a pretty option. Then go for iShares Micro-Cap (IWC).

Source: Playing The January Effect