The January Effect: Fact Or Fiction?

The January Effect is a calendrical hypothesis that suggests stock prices tend to rise more in January than any other month. While it seems to have held some truth historically, nowadays many doubt the January Effect’s legitimacy. 

So, is this 80-year-old hypothesis a thing of the past – or is it something you should prepare for? 

A brief history of the January Effect

The January Effect was first noticed by investment banker Sidney Wachtel in 1942. During his studies of market returns dating back to 1925, he noticed that stocks tended to see greater gains in January than other months. 

Later, this theory was confirmed by multiple academics and spread to studies of other asset classes. As it evolved, some proposed that the January Effect was the result of smaller stocks outperforming larger stocks at the start of the year. 

Why does the January Effect occur? 

Analysts have offered several explanations for this effect throughout the years with varying degrees of plausibility. But most likely, the January Effect occurs due to a combination of factors.   

Theory #1: Taxes

One is that the January Effect was the logical outcome of year-end tax-loss harvesting. As investors sell losing positions for the tax benefits in November and December, downward pressure lowers market prices. Then, investors repurchase their positions in January, driving prices back up. 

However, this theory doesn’t explain the January Effect in less-developed markets or economies that don’t charge capital gains taxes. 

Theory #2: Holiday bonuses and investor psychology

Another potential explanation that aims to square this circle is that investors use year-end cash bonuses to purchase investments in January. Some analysts also suggest that January is the time for investors to follow through on their New Year’s financial resolutions, leading to increased trading activity. 

That said, individual investors’ effects on the market are often overshadowed by institutional and high-frequency traders’ activities. As such, these explanations – at least by themselves – seem unlikely. 

Theory #3: Institutional marketing 

When the January Effect peaked in the 1970s and ’80s, a third explanation arose: window dressing. Essentially, this occurs when portfolio managers sell risky positions in December to keep them off a fund’s annual report. Then, institutional investors pile back on in January. 

Several studies have found that riskier small-cap stocks tend to see the highest returns in January, lending credence to this theory. 

The January Effect in 2022

The first two weeks of 2022 have been rough for the stock market as the S&P 500 posted the worst start to a year since 2016. So far, the benchmark index is down 1.5%, while the Nasdaq Composite is down over 4.3%. Meanwhile, the Dow Jones Industrial Average is holding just about flat. 

Much of the new year’s flagging performance can be attributed to investors’ concerns that the Federal Reserve may raise interest rates faster than anticipated. Poorer-than-expected December employment data may also add to investors’ unease. 

Verdict: Should investors count on the January Effect?

Several studies have confirmed that small cap stocks can outperform their larger counterparts in January. But that doesn’t mean that they always do. 

In fact, the frequency and severity of the January Effect has waned substantially since it was discovered. The last decade or so has seen the most prominent decrease as markets have largely adjusted for its appearance and more people park their funds in tax-advantaged retirement plans. 

As a result, it’s probably best to avoid hinging your investment strategy on the possible appearance of a seasonal anomaly (especially one that, for the most part, no longer holds true).

Instead, a buy-and-hold strategy based on methods like dollar-cost averaging and value investing may be a better way to get ahead and build your wealth. 

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