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January Effect: Overview, Meaning and Cause

Trading

Megha Parmar

23 Dec, 2022
5 mins read

An axiom prevailing in the Indian stock market is that no arbitrage is here to stay for long. That’s because investors and traders will encash it as soon as it makes an appearance. And once it is gone, individuals as well as investors wait for a new arbitrage opportunity. One such arbitrage occurrence was termed as the “January effect” by the American investment banker Sidney B. Wachtel in 1942.

The notion of the "January effect" emphasizes the stock market's propensity to rise in January relative to other months. There are multiple reasons that could be connected to this subject, but the most prevalent is that investors give their portfolios a new start by returning to the stock market after selling their stocks at the end of the year in order to lock in their losses.

While some investors are still dubious about its existence, some wonder how it has managed to stand through the ravages of time. Today, let’s have a rendezvous with January effect, what causes it and whether it really stands true in the dynamics of the Indian stock market or not.

What is January Effect?

The January effect is the observed phenomenon wherein the small stocks outperform the broader market in the month of January. Small stocks display a lot of discrepancy in the mid of January due to an increase in buying followed by a drop in price. Usually, this seasonal phenomenon targets the small caps rather than the mid-sized or large ones. This is because they are less liquid in nature as compared to the mid-sized and large caps. January effect happens for a lot of reasons. Let’s unravel them one by one.

What Causes the January Effect?

Heard of the tax-loss theory? Are you familiar with the phenomenon of window-dressing? Well, when it comes to the January effect, there are umpteen reasons for its occurrence. However, financial experts accredit this calendar anomaly to only a handful of them. These are:

1. Year-end Bonuses

Post-new year, companies often compute and credit the year-end bonuses in the salaried accounts of their employees. Year-end bonuses turn out differently from the reversionary bonus. Since there is a rise in the real income of the employee in the initial month of the year, they start buying stocks and securities. As this stands out to be the work ethic or norm in most of the Asian subcontinent, there is a steep rise in the demand for securities, assets, and stocks.

2. Rebalancing One’s Investment Portfolio

Back in the 1970s and 1980s, the January Effect was at its brawniest, all because of the process of re-balancing of portfolio by expert traders and investors. Re-balancing the portfolio involved selling-off the risky securities, stocks as well as assets in the month of December to eliminate them from the annual report of that fund or trading account. Once the calendar accosts January, they start piling back into these very small funds or caps. This is also termed as “window dressing”. Experts of the money and financial markets consider this as a plausible cause of the January effect since these perilous securities, stocks as well as assets yield lucrative returns on being piled back in January. Another version of this cause could be the selling-off these securities, stocks, and assets when an investor had got a sufficient return by the end of the year just to replace them with low-risk bonds. And then, in January, they used to pile back and drive a lucrative return.

3. Year-end Performance

In the context of the Indian stock market, it is seen that the performance in the month of December is all about the selling hype that brings the price down. This always triggers the buying spree by the investors in the month of January culminating into the “January effect”.

4. Harvesting the Tax-loss

One of the simplest causes of the January effect is the theory of tax-loss. It is seen that taxpayers tend to sell-off their trade holdings to harvest the tax-loss or the capital losses. They do this to shoehorn this very loss in the next year’s tax returns. This creates a blanket of pressure leading to a sheer drop in the price. Later, in January, they come back with the bang and start buying again altogether.

5. Mutual Fund Managers Are Always in Action

Mutual fund managers always act upon eliminating losses in their fund reports, that can bring them under scrutiny. In addition to that, they also buy the top-performing stocks or securities by the end of the year and practice “window dressing” with them.

6. Consumer Sentiment Associated With January

Sentiments often play an invincible role in our decisions as well as resolutions. Since January is the first month of the year, this very consumer sentiment combined with the investor psychology signals a trader to initiate investment. This gives a boost to buying in the month of January.

Does the January Effect Still Exists?

Remember the stock market adage – “As goes January, so goes the year”? Well, some people tend to confuse it with the January effect and assume the effect to last only till late January. However, this does not hold true. In some markets, where there are not any capital gains, the January effect can stretch itself till a couple of months. This is because in the absence of capital gains, December is relieved of the artificially created pressure to sell-off. So, the stay of the January effect demands entirely on the nature of the market.

A respectable number of scholars still apprehend that the January effect does apply to certain assets, stocks and even to less-dynamic markets. In the same vein, several studies have authenticated that small caps can outshine large caps in the month of January. So, can we say that this effect still stands tall? Not in its entirety since there are not any logically conclusive findings that can corroborate this is always true. In fact, the last decade has seen a substantial wan in this seasonal anomaly largely because people have started parking their assets in tax-advantaged trading accounts. So, what should an investor do?

It is recommended not to hinge one’s investment objectives based on this calendar anomaly. An investor or a trader can use various buy-and-hold strategies to proceed further and mint wealth. Likewise, one can spare some time in understanding the fundamentals of various companies to devise a better strategy in the month of January.

 

Final Words:

The growth potential, the incurred profit margins, the revenue generated, the market position as well as the management tactics of a company will assist you in comprehending the price movements and potential swings, boosting your confidence to sail through the turbulent waters of the Indian stock markets. January Effects are calendar theories about market movements, but they are impossible to predict and can't be predicted in advance. A cautious approach should be taken by investors who are considering taking the January Effect advantage.

With that being said, we wish you a happy trading experience in coming January! Trade wisely.

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