How Can the January Effect Impact Stock?
The January effect is a theory that seeks to explain why stock prices increase during the month of January. The turnover of the new year incentivizes investors to buy more stocks, and this incentive starkly contrasts December's trend toward massive sell-offs. Another factor that contributes to the January effect is the trend of investors using year-end bonuses to purchase new investments during the first month of the year.
The existence of this effect is predicated on the fact that the markets are inefficient, and the main underlying reason for the existence of this effect seems to be the arbitrary division of market milestones by the calendrical year. Since the discovery of the January effect, it has been noted that it seems to impact small-cap stocks more than mid-caps or large-caps, which are less liquid.
Other Potential January Effect Explanations
It's possible that the January effect can be chalked up to something as simple as New Year's resolutions. Investors who performed badly in the previous year may use the first month of the year as a springboard to boost their success, and increased buying is one of the only ways to improve your potential to achieve in the markets.
Some analysts have suggested that the practice known as "window dressing," in which mutual fund managers purchase top performers and drop losing stocks to make their end-of-year portfolios look better, could contribute to the January effect.
This hypothesis is unlikely to be true, however, since the January effect predominantly impacts small-cap stocks.
Overall, the theory that the January effect is caused by stock purchases made after investors receive end-of-year bonuses holds the most credibility. These bonuses are commonplace in the investment industry, and when you have extra cash to play around with, it's likely that you'll be pressed with an urge to reinvest it at the closest possible opportunity.
History of the January Effect
Investment banker Sidney B. Wachtel was the first to note the January effect. He pointed out that small stocks had outperformed the rest of the market every January since 1925. This observation was seemingly corroborated by a study that analyzed market data from 1904 to 1974, which concluded that the average return on stocks during January was five times greater than returns from any other month during the year.
A second study based on data from 1972 to 2002 supports the conclusion that the January effect impacts stock performance, but this study found that this outperformance margin was only 0.82 percent. Additionally, the stocks that outperformed in January underperformed for the rest of the year. Historically, the January effect seems to be more pronounced when a new president enters his third year in office.
Does the January Effect Impact Investors?
Opinions on the impact of the January effect vary. While its true that, historically speaking, stocks do increase in price in January, this effect has become less and less noticeable in recent years. Some analysts believe that the market has accounted for the January effect, and they contend that this effect will probably be non-existent within a matter of decades.
On the other hand, even as the January effect continues to have less and less of an impact, the third year of a presidential term will still produce the most significant January effect, so investors should be prepared for this phenomenon at the start of 2019.
The aspect of the January effect that is most pertinent to investors is whether or not this slight rise in stock prices at the beginning of the year offers any opportunities for success in the markets. For investors who are wondering whether or not the January effect will be their big break, the answer appears to be a resounding "no."
Burton Malkiel, an ex-director of the Vanguard Group, is on record as stating that the January effect doesn't provide any predictable opportunities for investors. His argument against the validity of the January effect is that the transaction costs required to make any profit from this tiny bump in prices make it unprofitable.
The more people who know about the January effect, the less of an impact this effect will have. These days, investors are highly educated on all of the different ways that they can improve their profits, which means that if there ever was anything to the January effect, that ship has long sailed.
If you're after long-term success trading the markets, its best to approach your goal slowly and steadily instead of veering off the path every time something like the January effect comes along. While it still may be possible to make a profit off the January effect if you're a seasoned investor, newbies who are looking for their big chance should stick to the basics and trade with long-term goals in mind.