January Effect

Wed Jan 12, 2022, 08:54 pm | by Dan Schmidt | No comments

Investors tend to be a superstitious group. While the January Effect may sound more like the title of an apocalyptic sci-fi movie than an investing theory, it is one that many stock traders have discussed at length. Timing the market is usually a fool’s errand, but there’s often enough data behind these ideas that investors need to at least consider the possibilities (and the ramifications for their portfolio). And while something like the January Effect is sure to induce some eyerolls, it’s an interesting concept that helps explain the role investor psychology plays in markets. 

What is the January Effect?

You’re probably more familiar with cliches like “Sell in May and Go Away” when it comes to markets, but the January Effect is another idea that has gained significant traction from market participants. The idea goes like this: a number of different factors come into play at the end of the calendar year that causes stock prices to fizzle. Investors sell off their underperforming stocks in order to capture offsetting capital losses to their gains and fund managers remove losers from their portfolios.

In January, however, these stocks are repurchased after wash sale rules have been satisfied. Additionally, year-end compensation bonuses can be put to work in January and portfolios will be rebalanced as the new quarter begins. This confluence of factors results in the outperformance of stocks in January, at least according to this hypothesis.

Indeed, the January Effect was a hard phenomenon to ignore in previous decades. A data study from the Wall Street Journal found that between 1950 and 2000, investors enjoyed significantly better returns on average in January compared to the remaining 11 months of the year. Investors who levered up during the first month of the year were handsomely rewarded for their extra risk taking.

But like all advantages in capitalism, word gets out and the edge is filed down into a nub. Since 2000, the January Effect has been less prominent in stocks and has even produced some negative returns. Bonds have performed well in January, but the effect hasn’t always held true in equities. Still, plenty of examples of this phenomenon still exist and even as recently as 2018, stocks saw a December slump turn into a massive January rally. It’s important to remember that ideas like the January Effect are just theories. Ignore them at your own peril, but don’t relinquish your skepticism either.

January Effect Explanations

  • Tax-Loss Theory – If you’re an active investor using a taxable account, you’ll likely owe capital gains taxes at the end of each year. Depending on your income, this could result in a 15% or 20% haircut on your profits. But the government allows inventors to offset these capital gains with capital losses, provided the rate is the same (long-term vs short-term). In December, it’s not uncommon for investors to sell off some losing investments in order to reduce their capital gains taxes. But that capital loss can only be counted if wash sale rules are adhered to, meaning the investor cannot buy back the same stock within 30 days of selling at a loss. The theory goes that investors sell their losers in December to reap the tax-loss savings and then buy them back 30 days later in January. 
  • Year-End Bonus Fuels Trading – Here’s a theory that’s difficult to disprove, especially after seeing young people plow their stimulus checks into stocks and cryptocurrencies. Year-end bonuses are windfalls to employees and after taking care of holiday gift buying, much of the remaining cash winds up in the market. If you were expecting a $1000 bonus and instead received $1500, a prudent move is to put that extra $500 into the markets, especially if you haven’t yet maxed out your 401(k) and IRA.
  • Portfolio Rebalancing – The end of the year also draws Q4 to a close and that’s a prime spot for investors and fund managers alike to rebalance their portfolios to get back in line with risk tolerance. For example, tech stocks boomed in 2020 and many investors found themselves very tech-heavy as the calendar changed to 2021. A portfolio rebalance would see some of these tech stocks get sold for more exposure in other sectors like energy, industrial, or consumer discretionary.

How to Prepare for the January Effect as an Investor

  • Small Cap Strategy – The January Effect is far from universal, but the effect does seem more pronounced in small caps recently compared to large caps. If you want to trade the January Effect, consider adding small caps in your taxable account.

  • Do Not Time the Market – Having a trading plan in place so you can follow rules instead of gut feel. Timing the market is almost always a bad idea, so always have an entry and exit strategy mapped out.

  • Buy and Hold Strategy – For the majority of investors who aren’t actively trading, the best strategy is often to just do nothing. If stocks run up in January, you’ll reap the benefits as long as you stay invested. And if stocks are flat? You can be thankful that you didn’t lever up to take advantage of an hypothesis that never materialized.