What is the January Effect?

The January Effect refers to a pattern exhibited by stocks -- particularly small-cap stocks -- in which they've shown a tendency to rise during the last several trading days in December and then continue to rally throughout the first week of January.

How Does the January Effect Work?

Several theories have been put forth to explain why the January Effect occurs. One such explanation holds that mutual fund managers will sometimes go shopping at the end of December to purchase stocks that have appreciated significantly during the year -- a deceptive practice, known as 'window dressing.' Any holdings that a fund owns at year-end will be listed in its annual report to shareholders, and it always looks good for a portfolio to contain a few extra 'winners.' Demand from these institutional investors can sometimes drive prices higher.

Furthermore, as the end of the year approaches, many investors unload shares of poorly performing stocks. Some of them may be simply trying to cut their ties to bad investments in order to get a fresh start to the new year. Primarily, though, year-end trading is heavily influenced by tax considerations, and many people will sell their losers in order to realize capital losses that can be used to offset capital gains elsewhere. Once the new year begins, the proceeds from those sales are often redeployed back into the market, thereby sending stock prices higher.

Finally, the last explanation can be attributed to investor psychology. For many people, the beginning of January is simply a popular time to invest. Saving more money may be a New Year's Resolution for some, or a way to put year-end bonuses to work. Whatever the reason, stocks typically trend higher at the beginning of January.

Why Does the January Effect Matter?

Many studies have confirmed the existence of the January Effect; one in particular examined historical data from 1904 to 1974 and found that the average return during the month of January was five times greater than the average during the other calendar months of the year. The pattern is particularly noticeable among smaller companies. One study conducted by Salomon Smith Barney discovered that between 1979 and 2002, small-caps (as measured by the Russell 2000) outperformed large-caps (Russell 1000) by an average of 82 basis points during the month of January, yet they lagged during the rest of the year.

On the surface, it would seem as though the January Effect would be an easy trend for investors to take advantage of. However, in recent years it has become far more difficult to profit from the phenomenon, as it is becoming increasingly less pronounced. There are a variety of reasons for this. For starters, investors are saving a larger percentage of their assets inside tax-sheltered accounts like 401(K)s and IRAs, reducing the need for tax-loss selling. Furthermore, with so many people anticipating the early-January rise, the effect has largely become priced into the market, as stock prices adjust ahead of time. This in turn has given rise to the so-called 'Santa-Claus Rally' -- a period of buying before the onset of the January effect. While these curious trends are worth monitoring, most analysts agree that they are not a reliable way for investors to reap easy short-term rewards.