If you are new to the stock market or simply looking to understand the twists and turns that it entails, I want to introduce you to the January Effect. This term refers to the stock prices increasing during the month of January. This increase is generally due to the excess selling and subsequent buying that happens in late December/early January.
The January Effect most often affects small caps as opposed to large ones. Small caps are companies who have a small market capitalization. Historically, it has been these companies that have outperformed the market as a whole during the month of January.
You may be wondering why exactly the January Effect happens, and it is honestly most likely due to a couple of different reasons. One of which is tax-loss harvesting. Tax-loss harvesting occurs when retail investors sell back their losing stock at the end of the year as a way to improve their overall position for their taxes. They will often buy back those stock in January – leading to an increase in price.
Another reason that the January Effect could happen is due to something called Window Dressing. This is when a mutual fund manager will shop in December to purchase stocks that have appreciated throughout the year. This gives them a chance to present a better-looking annual report to their shareholders when the time comes.
A further hypothesis as to the reason for the January Effect is the fact that people are receiving year-end bonuses and then turning them around and putting them to work in the market. This bump in income could be a reason that the prices rise.
Late December into early January can be a great time to take advantage of the impending January effect. It can be a great way to add smaller companies into your portfolio right before they see a boost in the market. A word of warning though, this time of year is not ideal for those who focus on momentum investing, but it will be an advantage to those who are driven by the size effect.
The January Effect has been happening steadily for many years but what is the future of the phenomenon? More and more, it seems as though the market has been adjusting to the effect and causing less to happen. Tax-loss harvesting is becoming easier for investors to accomplish through automated trading which in turn could lessen the effect that it has in January. More people are also utilizing tax-sheltered retirement plans which makes them less likely to sell off stocks at the end of the year.