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The January Effect

The beginning of a new year always brings some important changes, beyond the purposes and goals that each one has been able to set. Apropos of this, we talk about the January effect as a very particular stock market phenomenon, which can be observed with small-cap stocks, and which would explain a certain upward trend in their price. Have you ever heard of this? Keep reading and we’ll tell you a little more.

What is the January effect?

As mentioned, the January effect is a stock market phenomenon. It consists of an unexpected rebound in quotes, which takes place in the first days of the year, producing abnormally high returns, compared to other times.

It is also known as the “year-change effect” and is part of the set of phenomena grouped under the concept of “calendar anomalies.”  Usually, it is opposed to the decreases in the quote, which often occur in the last days of December.

This effect has been observed to be true in most years: 88% of the time. However, there are also exceptions; for example, when there are energy crises; or as in 2008 when the real estate bubble collapsed in the U.S. market.

Usually, it affects the value of the shares of smaller companies, whose quotes are more volatile. But this does not mean that it cannot be extended to other values.

In fact, according to some studies, there is evidence of its impact on the bond market. The January effect is also evident in several markets, as indicated by various indicators; for example, in 2021 the S&P 500 rose by 2.4%. Likewise, the values of gas and oil companies recovered, after a decline in the previous year.

Why does the January effect occur?

There are various hypotheses that have been proposed to try to explain the existence of this effect. But, apparently, none of them ends up constituting a plausible explanation. Let’s see which ones are the most accepted.

According to the tax hypothesis, also called the tax loss hypothesis, the possible explanation for this phenomenon would have to do with tax reasons, in the sense that some agents would seek to sell the securities that have had losses in their quotes at the end of the year.

On the other hand, it would be an investment strategy, with which profits are obtained, by buying securities whose prices are at a minimum the last week of December and then selling them in January.

According to the hypothesis called makeup of wallets, during the month of December, managers can sell assets that have not been popular, so that they do not appear as part of their portfolio in the annual report. Then, once they had attracted new clients, they would start a more aggressive stage in the investment policy, in order to outperform their competitors. 

In the same way, the psychological factor should be taken into account, since there are many who think that the month of January can be a good time to buy. Which would explain the rise in some prices.

In this sense, it is likely that investments will be made at the beginning of a new year, as part of the formation of portfolios, knowing that such decisions can be changed in a timely manner.

And the fact is that at the end of a year, there is a better assessment of the performance of certain securities, the returns of investment funds, etc., so at this moment the outlook for investing may be clearer.

Other factors that may influence the January effect are the existence of greater liquidity (due to the contribution to pension plans, among others), which will be invested in the first month of the year; also, some investment decisions are postponed in December, due to social, family commitments, etc.

Implications and consequences

In general, it is thought that the trend in the first month can mark the behavior of the stock market for the rest of the year. In this sense, if January is bullish, it is assumed that the other eleven months will also be bullish, and vice versa; although this is not a law.

For those who firmly believe in this pattern, the aforementioned year of the financial crash can be a clear example: in spite of several previous periods of bullishness, January 2008 was one of the worst in history, a sign that something was coming.

But other sources assure that this is not infallible. While there may be a correlation, it is possible that a bullish January precedes a bearish year, as happened, exceptionally, in 1966.

Of course, the January effect it’s a good thing for those companies whose stocks are on the rise and for the holders of such shares, who may choose to sell in a favorable position or opt for other strategies.

In this regard, it is suggested to take advantage of the January effect in several ways:

  • It can be traded in futures and options on indices.
  • Participation in investment funds specialized in small companies.
  • Individual common stocks, particularly those priced below their maximum averages.

Is January a good time to invest?

Despite the fact that the January effect is present at the beginning of each year, some consider that its impact tends to be less and less decisive, to the extent that the markets have already been adjusting to this phenomenon.

On the other hand, we must remember that the January effect is not infallibly fulfilled in all years or with all small capital companies, but there is always a margin of error (it is estimated that up to 12%).

Likewise, the past behavior of financial markets is not a faithful indicator of what may happen in the present. Therefore, investments based on this type of predictions must be made very carefully, to avoid possible economic losses.

In any case, we can conclude that, be it January, August, or December, it will always be a good time to invest, if we study the market, if we are attentive and if we find a good investment opportunity; moreover, if we know how to take advantage of it. 

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