5 Reasons to Ignore the January Effect

By Darwins Money on 9 December 2010 (Updated 16 December 2010) 5 comments
Photo: BamBamImages

It's that time of year where the stock-market myth about the January Effect rears its ugly head, so it's also time to point out why investors shouldn't alter their existing investment strategies to try to chase returns that are no more likely to materialize than if they did nothing at all.

The concept of the January Effect is that stock prices tend to increase in the month of January each year, more so than other months. Therefore, investors who purchased securities during the month of December are, in theory, likely to be rewarded with outsized gains if they sell later in January of the new year. The concept gained prominence in the 1980s based on a review of historical data showing the phenomena was relatively common going all the way back to 1925. The theory is that in December, investors sell losing stocks at year-end to offset capital gains elsewhere, thus artificially depressing share prices of stocks that were already negative on the year. Investors then swoop in and re-buy those same shares in January.

According to a recent CNBC article, December is the new January, and investors should start buying now. They go on to recommend purchasing this year's losing stocks in the S&P 500 index. Well, I'm not buying it at all. Here are several reasons why this advice should be ignored:

Market Efficiency

There's an age-old debate about efficient markets and whether the theory holds true, but in essence, many economists believe that there is so much information provided to the investing public in real time, that at any given time, asset prices do reflect all currently known information, and thus assets are fairly valued. While some would counter that insider information and near-term panics like the recent flash-crash alter the notion of efficient markets, the January Effect would be immune to these characteristics (i.e. no more likely to experience insider trading than any other stock). In this particular example, since the January Effect myth is so widely propagated, it is unlikely to occur each and every year without investors arbitraging the spread in performance and reducing it to random chance.

The Internet

The Internet takes market efficiency to a whole new level. Whereas historically the January Effect was relegated to academic papers, books, and newspapers, now there are instant reminders like the aforementioned CNBC article constantly prompting investors to fulfill the prophecy. This just results in front-running, hence eliminating the purported benefit.

It's Not Guaranteed

There have been some years where the January Effect did not achieve its desired effect. Do you want to experiment this year and find out if this is one of those years? Investing in an FDIC-insured CD provides you with a guaranteed return. Stock market investing does anything but.

Standard Deviation and Investment Risk

Would you bet $100 to win an extra $1 in a game of chance? Probably not. While overly simplified, the concept holds true. If attempting to exploit the January effect, you are, in essence, taking on market risk with very high volatility for a marginal return. By subjecting yourself to a brief attempt to "beat the market" with this gimmick, you're putting yourself at undue risk given the relatively paltry return.

Commissions, Taxes, and Net Benefit

Shifting money from your existing holdings in order to exploit this supposed effect and then selling again within a month is likely to erode any possible benefit that was realized. Not only would you incur commissions on the buying and selling, but you will have generated tax liabilities on the strategy as well. At the end of the day, what will the net benefit be? A highly randomized return minus commissions.

To recap, it has been proven time and time again that the best approach for retail investors is to stick to a long-term investment strategy focusing on diversification and low fees, and not reacting to external market jitters and hype. I may well be proven wrong come January, but I would chalk that up to random chance. I'll take my boring, ETF investing approach any day.

Are you going to experiment with the January Effect?

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Guest's picture

Excellent post. You are absolutely right in that most investors should ignore these types of theories and stick to a longer-term strategy that fits their financial goals and risk tolerance.

Darwins Money's picture

Thanks Roger. New investors especially, end up getting caught up in newfangled investment myths and hype and often throw good money after bad chasing what they believed to be a sure thing. If it were, the experts with faster, cheap, research-driven capabilities would ensure this thing is arb'd to zero anyway.

Guest's picture

As a graduate student I don't have a lot of money to invest. I think the best thing to do when going into investing is research, research, research. The lure of potentially "free" money probably sets the bar low for people wanting to get into investing, especially if they already have money. This often sets up a situation where people go for quick and easy tips that is supposed to make them quick money. People don't realize that this often backfires, and they have a high probability of losing money instead.

Guest's picture

Bravo! Very nice post. we'll be sticking with my investment strategy then.

Guest's picture
David

You can't go wrong with investing for the long-run, but many bad things can happen if you're playing the stock market for a 1-month quick gain.

The commissions and taxes are a big point. In order to offset the commissions for buying and selling as well as the taxes, you're going to have to put a lot of money in the market to make it worthwhile, which makes this venture even more riskier.