What is the January effect?
The January effect is the hypothesis that share prices are higher in January compared to the other months of the year. Whether the January effect can actually be observed depends heavily on the period, region and asset class (small vs. mid and large caps). One possible explanation for the increase is probably due to tax effects . Loss-making shares are sold shortly before the end of the year. The losses are then offset against the gains, thus reducing the amount of capital gains tax. The shares are bought back in January. Another theory is that investors invest their year-end cash bonuses in January. Like other market anomalies and calendar effects, the January effect is seen by some as evidence against the efficient markets hypothesis.
The January effect seems to affect small caps more than mid or large caps, as they are less liquid. Since the beginning of the 20th century, data has indicated that these asset classes have outperformed the overall market in January, particularly in the middle of the month. Investment banker Sidney Wachtel first noted this effect in 1942. However, the January effect has become less pronounced in recent years as the markets seem to have adjusted to it.
Reasons for the January effect
Apart from the use of tax losses and buybacks and the fact that investors invest cash bonuses, another explanation for the January effect has to do with the psychology of investors. The theory is that some believe that January is the best month to start investing. This is comparable to a New Year’s resolution.
Another explanation is “window dressing”. It is assumed that fund managers buy shares in top performers at the end of the year and sell questionable losers so that they do not appear in the securities portfolios or their annual reports. The fund managers carry out this activity in order to “beef up” their portfolios. However, this theory is controversial, as such buying and selling would primarily affect large caps, for which the January effect is less pronounced anyway.
Year-end sell-offs also attract buyers, such as value investors, who are interested in the lower prices as they know that the price falls are not based on company fundamentals. If this happens on a large scale, it can drive prices up in January.
Criticism of the January effect
A former director of the Vanguard Group, Burton Malkiel, who also wrote the book “A Random Walk Down Wall Street”, is a critic of the January effect theory. He believes that seasonal anomalies such as these do not provide reliable opportunities for investors. He also claims that the January effect is so small that the transaction costs required to exploit it make it essentially unprofitable. There is also the possibility that too many people try to use the January effect to their own advantage, so that it is priced into the market, which in turn destroys it.
However, this is a constant debate in the financial sector as to whether the markets are efficient or not. Value investors, for example, assume that there are always inefficiencies, which can be used to buy shares on the market below their intrinsic value. Regardless of whether markets are efficient or inefficient, it makes sense to focus on the fundamentals and qualitative criteria of individual companies when investing. A good asset manager can help to identify the most promising investment opportunities in any market situation.