January effect

The January effect refers to investors’ belief that there is a seasonal anomaly where small capitalization stocks outperform large capitalization stocks in the first month of the year. Research suggests that, while there is indeed a January effect, the size of the effect has been decreasing and it is probably to too small for investors to exploit. Nevertheless, investors’ behavior might help explain the presence the January effect.

Behavioral explanations

The first behavioral explanation is tax loss harvesting. Often, investors’ realised capital gains are taxed. At the same time, these investors can also deduct realised losses. If that’s indeed the that case, then it makes sense for investors to sell positions that have lost money. These realised losses can be subtracted from realised gains. At the start of next year, investors might then buy back the stocks they sold for tax purposes, because they never really intended to actually close down these positions permanently. If these tax-sensitive investors tend to hold smaller capitalization stocks, this buying pressure might drive up prices of these stocks in January, causing the January effect.

A similar effect could be at play in the case of institutional investors. These institutional investors, e.g. fund managers, are often evaluated at the end of the year. Quite often, end-of-year rankings of mutual funds are generated and the portfolio composition is communicated to clients. Of course, it’s always nicer to report a portfolio that consists mostly of winning stocks. Thus, institutional investors tend to sell their losing stocks before the end of the year to make their performance look better. This behavior is called window dressing. These investors too might then repurchase their positions at the start of next year, driving up prices.

January barometer

The January effect is sometimes mixed with the January Barometer effect. The January Barometer effect argues that “As goes January, so goes the year”. As such, a first positive month would indicate a positive year for stock returns. In practice, the January barometer effect is a myth, rather than a reality.

Summary

The January effect is not a behavioral bias itself. However, we discussed at least two potential behavioral explanations that might cause such a pattern to arise around the start of the new year. However, even if a January effect is present, it is probably too small and there’s little use in trying to exploit it.

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