What Is The January Effect?
The January Effect is a calendar anomaly sometimes observed in the market where stock prices, especially those of small-cap companies, tend to increase slightly more (on average) during the month of January than in any other month of the year.
Some traders believe that the January Effect is a reliable ‘calendar effect’ that can be used for trading opportunities – in other words, 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.
Why Does The January Effect Happen?
The January Effect does not always happen and no one knows exactly why it does, though several potential explanations have been put forth. For example, many analysts believe it is related to tax-loss harvesting before the end of the year, where investors may sell positions that have declined in order to take the capital loss in that calendar year's taxes. Those investors then repurchase the same stocks in January of the new year.
The income tax theory believes that individual investors, who hold more small-cap stocks, sell stocks in December in order to claim a capital loss on their taxes. They then reinvest in the market in the new year, driving stock prices higher for the small-cap companies they are more likely to buy.
Others believe the January effect is caused by people getting year-end bonuses and investing them in the market, or by end-of-year contributions to employee pension and 401k plans. It could also be caused by domestic and international investors using the new year as a reminder to invest money in their registered accounts. For example, Canadian investors are allowed to add limited additional funds every year to their tax-free savings accounts (TFSAs) and registered retirement savings plans (RRSPs).
Another influence could be psychological factors. With many people reflecting on their previous year and resolving to start the new year differently, it's conjectured that they might be adopting a new investment strategy or getting more serious about investing in early January as part of a new year's resolution.
First observed by investment banker Sidney B. Wachtel in 1942, it was noted that from 1925, small-cap stocks outperformed the broader market in January, especially before mid-month. While some studies have confirmed that returns are often higher than average during January, it appears to have decreased in significance of its impact over the years – potentially because tax-sheltered investment vehicles make selling to lock in a tax-loss less important as an investment and tax planning strategy. While it can still occur, it’s often not significant and it’s hard to predict when the January Effect will be more pronounced.
Tip: The January Effect does not always happen, as small-cap stocks have sometimes underperformed the broader markets. This was the case in 1982, 1987, 1989, and 1990, when no January Effect was seen.
How Frequently Does the January Effect occur?
Historically, the January Effect is observable in most years, but the fluctuations are much more subtle than they were in the middle of the 20th Century when it was first observed. However, while there have been years where there were moderate declines in stocks in January, sharp declines are not common.
Investors considering January Effect investing should be cautious. Calendar theories like the January Effect and the Santa Claus Rally are just that – theories. No one truly knows why they happen when they do and they cannot be predicted. They do not forecast market behavior and the market can and often will defy the wisdom of these theories. They might also be costly to take advantage of with transaction fees involved in buying and selling your positions and the time cost of researching small-cap stocks that are well positioned to take advantage of the January Effect.
If the calendar theory effect doesn’t take place that year, if the opposite occurs, or if the effect is not as pronounced as expected, investors could suffer losses.
Tip: While the market may exhibit a statistical advantage to positive returns in January, such tendencies are measured over decades and can be subdued or not hold at all in any given year. Also, the differences between January and other months can be slight and are not appreciably different from long-term average returns in April, July, and December.
The January Effect is a calendar theory about movements in the market, but there is no way to predict if it will take place in any given year or how pronounced it will be. Investors who consider trying to take advantage of the January Effect best be cautious.