What is... | January 3, 2013

What is the January effect?

January means New Year resolutions and new starts in life - and some associate the month with above-average returns in share markets.

At the turn of the year, financial markets may get caught up in the so-called January effect. The arguments supporting why that happens are relatively straight forward but it gets complicated because some research indicates the January effect doesn’t work (or has stopped working). 

Buy and sell
The Washington Post reports investment banker Sidney Wachtel coined the term in 1942 and it is one of a family of so-called calendar effects.

The Behavioural Finance portal lists research on the topic and alludes to the argument that returns on shares tend to be higher in January because of particular ebbs and flows in trading patterns. Reuters writes that towards the end of a year, investors and institutions might sell stocks for tax purposes and “portfolio dressing”  – or buying and selling to impress investors. If many shares are sold, the price typically falls. But in the New Year, the argument goes, investors start to buy them back and the price rises.

Is it real?
Despite talk of the January effect perpetuating for many years, some research says the effect is not actually true or not as it seems.

In the Journal of Investing in 1998, academics disproved the idea that the effect is driven by tax loss selling. New Zealand researchers wrote in 1994 that the effect did not hold true and suggested the small size of the market and its poor liquidity may be among the causes. In addition, Princeton academic Burton Malkiel writes that even if the January effect happened, once people notice it the effect diminishes if investors flood into the market in December (and push up prices) on the hope prices will rise in January. Malkiel adds that even if gains can be made by buying low and selling high, these gains are relatively small in comparison to the transaction costs involved.

The January barometer
Another concept commonly featured in financial media is called the “January Barometer” or “the other January Effect”. It refers to the saying “as goes January, so goes the rest of the year” in which good stock market performance in January is said to bode well for the rest of the year. If January is not so good, then the outlook is a little less bright.

However, as Chris Dillow blogged earlier, there are many studies that show that this “rule” seems to have broken down as the market evolved. “In the last six years, the ‘January barometer’ has failed as often as it has succeeded.”

Calendar effects
The January effect – whether true or not – is only one in a family of calendar effects. Intraday effects involve the increase in prices on the last day of trading, the weekend effect (also known as the Monday effect) refers to shares exhibiting relatively large returns on Fridays compared to those on Mondays and there’s even the Daylight Savings Anomaly where academics found that daylight-saving weekends are typically followed by large negative returns on financial market indices. They argue that the effect could be a direct result of changes in sleep patterns.

Of course literature could well exist disproving each of these effects too, as it does on the January effect.


eZonomics team
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