Since the 1970s, this has been one of the great adages of the share market and because most major share markets tend to track the US, it also bodes well for share markets around the world. Except for one thing – the January "rule" seems to have broken down.
Lessons of the Januarys past
The January effect has worked well for years. Research by Ben Marshall, an economist at Massey University in New Zealand, estimates that between 1940 and 2007, the US market gave a return of 14.4% in the 11 months after a January that saw the market rise, compared to a mere 3.2% in the 11 months after a fall in January.
However, the market has not behaved in line with the "rule" recently. In 2009 and 2010, the S&P 500 fell in January, only to do well in the following 11 months. In the last six years, the "January barometer" has failed as often as it has succeeded. Common sense tells us why this should have happened. Imagine it is late January. The market has fallen, and lots of investors believe the adage. Naturally, then, they sell shares. But this drives their price down, to a level from which they subsequently have a good chance of recovering.
Don't get noticed
And herein lies a general fact about financial markets - profitable opportunities can disappear when they become noticed. For example, in the mid-late 1980s, it was quite easy to make profits in the foreign exchange markets by following simple momentum: if the dollar has risen, buy it, and if it has fallen, sell. But these profits soon ceased.
Similarly, between the 1950s and 1980s, smaller shares rose even more than large ones. As people noticed this, specialist funds were set up to invest in them. But this merely drove their prices up to unsustainably high levels. Small caps then did badly in the 1990s.
Success can be an undoing
All of this corroborates a theory proposed by Andrew Lo at the Massachusetts Institute of Technology. Markets, he says, adapt. Sometimes, the chance to make money does emerge. But as people exploit this chance, it often disappears. It's like in biology. If a species discovers a new food source, it will eat well and reproduce. But as it multiplies, so it depletes the food and so the species ceases to thrive and might even go into decline.
The same thing is true of some investment strategies chasing profits. They succeed, they proliferate but then their very success can prove to be their undoing. However, the converse of this is also true. Again, in biology, if a species goes into decline, its food source might replenish itself as it faces fewer predators. And this might give an opportunity for others to eat well. In the financial markets, small shares give an example of this.
In 1998, Elroy Dimson and Paul Marsh at the London Business School pointed out in a paper that smaller stocks had done badly. And guess what? Shortly afterwards, they recovered.
Lessons to be learnt
The January effect demonstrates why it is so hard to make above-average profits in financial markets. The problem is not that markets are efficient and so embody all available information – though the extent to which this is the case must not be under-estimated. It is that even when they are inefficient and leave money on the table, the money can disappear shortly after investors realise it is there. If investors are late to the table, they are more likely to have a wasted and disappointing journey.
These difficulties in successfully exploiting apparent anomalies in the share market to get higher returns is one of the reasons some investors prefer to use passive rather than active funds when buying shares.