Trading The January Effect

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The January effect is a hypothesis that refers to belief among investors that there is a seasonal anomaly; in the month of January small market capitalization shares outperform the large market capitalization shares.

Research has shown that there is January effect but the size of this seasonal anomaly is decreasing over the period and too small for an investor to exploit.

Breaking Down January Effect: The January effect is attributed to several reasons; the first one is tax loss harvesting.

Tax Loss harvesting:  Tax loss harvesting is the practice of selling the shares that have experienced the loss. By realizing or harvesting a loss on certain shares; investors try to offset the taxes on shares where investors realized capital gain or value increase. To summarize; Tax loss harvesting is a strategy to sell-off shares at loss to offset the possible tax liability on capital gain in another set of shares.

Window Dressing: Window dressing is a strategy used by mutual fund and other portfolio managers near the year or quarter end to improve the appearance of a fund’s performance before presenting it to clients or shareholders. To window dress, the fund manager sells stocks with large losses and purchases high-flying stocks near the end of the quarter. These securities are then reported as part of the fund’s holdings.

Along with reasons like tax loss harvesting or window dressing, investors put cash bonuses into the market which is one of the reasons January market surge, another explanation for the January effect has to do with investor psychology. Some investors believe that January is the best month to begin an investment program or perhaps are following through on a New Year’s resolution to begin investing for the future.

On the surface, it would seem as though the January Effect would be an easy trend for investors to take advantage of. However, in recent years it has become far more difficult to profit from the phenomenon, as it is becoming increasingly less pronounced.

 

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