The month of January has an ambiance of new beginnings. As we enter the New Year, we are full of hope and motivation. While laymen worry about getting themselves summer ready, investors have other things to conceive. The straightforward phenomenon of another tax year beginning from January 1st, has led to the existence of the infamous January effect.
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The theoretical relevance of the January Effect is associated with the fact that every December stock prices take a dip and every January they receive a boost. This is driven by heavy selling during December and aggressive buying during January, particularly early in the month. Investors tend to sell off low-performing stocks at the end of each year. They then tend to buy those stocks back a few weeks or even days later.
In short, it provides us with a hypothesis to govern the seasonal anomaly in the financial portfolios where prices take an exorbitant surge in the month of January. This effect creates a golden opportunity for investors to buy stocks at lower prices in December, before the value increases. Individual investors who hold sensitivity towards income taxes, have disproportionately small stocks. They sell their stocks at the end of the year for tax related reasons and reinvest after the 1st of January.
The January Effect was first observed by Sidney Wachtel, an investment banker, in the year 1942. Looking at data from 1925 onwards, he noticed that small-cap stocks had outperformed the market in the month of January since a year i.e. he observed a pattern. Beginning from 1928, the S&P500 experienced a positive development in January in 56 years out of 91.
Ever since Wachtel’s observation, researchers and practitioners have actively investigated the relevance of this conception. The notified data demonstrates that the effect has become rather small recently. This has most-likely been driven by the fact that, as the January Effect has become more prominent, the markets priced the effect in.
The January effect is also termed as “Window dressing”. This is people who monitor funds, usually showcase their portfolio at the end of the year. They usually leave out the poor performing stocks and only report the winner portfolio. Therefore, fund managers might sell poor performing stocks in December and, if they believe in the long-term perspective of these stocks, buy them back in January. Some economists and experts argue that the January Effect is driven by the fact that bonuses are often paid at year-end and therefore, investors have excessive cash to invest in January. Apart from that, the January Effect might also be linked to psychology as the fresh year marks a beginning, it brings positivity in the markets. Many people start investing in the new year or open new positions simply because they feel that the new year marks a great time to start with.