The January Effect: Is It Real?

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As the new year begins, many investors are looking for two things. One is an indication as to what the year ahead will bring and the second is a competitive edge to help them achieve above average returns. One thing that seasoned investors look towards to get answers to both of these questions is a phenomenon known as the January Effect.

The January Effect holds that the stock market, particularly the market for small stocks, tends to perform disproportionally better during the first month of the year than during the others. Market watchers attribute this to the fact that investors like to sell stock at the end of the year in order to lock in a tax loss and then reinvest back into the market in January and thus push prices up.

Some also feel that stock market performance in January foreshadows what the upcoming year as a whole will look like. The theory goes that if stocks are up in January it will be a positive year for stocks as a whole.

But before you go radically altering your portfolio to try to chase after the “free money”, let’s ask ourselves an important question. Is the January Effect real? Does this phenomenon really exist?

There’s some empirical evidence to suggest that it does. Or at least it did.

Upon doing a little research, I found that the emergence of the January Effect started sometime in the 1910s. This is probably not an accident since taxes were introduced around this time and the leading theory for the manifestation of the January Effect was investors buying and selling their investments as a means of avoiding taxes.

And for a long time, the theory seemed to be valid. Through the early 1990s, small stocks had very consistently outperformed their large cap counterparts during the month of January (in 69 of 81 years through 1993 I read quoted in one study).

But then the January Effect stopped materializing. After so many years of history, why did this phenomenon suddenly disappear? The simple answer – everybody knew about it.

In the early 1990s, the theory of the January Effect became popular around Wall Street. Investment pros and individual investors alike wanted to profit from the seemingly predictable spike in equity prices at the beginning of the year and therein lies the problem. As soon as traders realized what was happening and markets became more efficient with the newfound information it could no longer be counted on.

The last 15 years have been a decidedly mixed bag. Small stocks have largely underperformed large caps during this period and during the “lost decade” of low stock market returns many years have seen losses in stocks. In short, there’s little evidence based on current market history to suggest that the January Effect still exists.

Theories are just that. Theories. They’re generally not based in fact and certainly shouldn’t be counted upon to materialize on a predictable schedule. The better bet is to just maintain your current asset allocation (after rebalancing for the new year of course!) and stay the path.

Chasing performance whether it’s in January or any other month is usually a recipe for misfortune.

Photo credit: nDevilTV

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Author Info

This post was written by David Dierking. David lives outside Milwaukee, Wisconsin and has been working in the financial services industry for over 13 years with a background in investments, accounting, and marketing. He earned his Chartered Financial Analyst designation from the CFA Institute in 2004 and was recently published in the Milwaukee Business Journal. You can also check him out at The Ultimate Fit Challenge

3 Responses to “The January Effect: Is It Real?”

  1. Mike Piper |  Jan 06, 2010 at 1:07 pm

    While I’m not one to believe that markets are 100% efficient (in that all stocks are perfectly priced at all moments), I definitely think that the market has a strong efficiency-seeking tendency.

    Any trading strategy that reliably beats the market, then becomes famous (as the January effect did) is sure to stop working.

  2. Penny Stocks |  Jan 07, 2010 at 8:01 am

    Traders like to play trends, use historical data, it can be a self fullfilling proficy. Start of the new year, what to invest in and they look at historical data and say XXXX stock does well in January we shoud invest. The cycle continues.

  3. Elaine @ O2 ideas room |  Jan 14, 2010 at 4:25 am

    Glad to hear your view on the reality of The January Effect, David. One of our O2 ideas room bloggers, Aidan Bodkin, has been outlining this for us in Ireland; and we’ve been trying to understand if we will see this happening here this Jan 2010.

    Thanks again for posting,

    Elaine @ O2 IdeasRoom