Throughout the year, as part of a thoughtful approach to wealth management, I try to minimize the potential taxes clients owe from gains in their portfolio. Often, in December clients will start asking about the January effect and whether they can take advantage of it.
Below I will share with you the most common questions, myths, and answers from my interactions.
What is the January effect and why does it occur?
The January effect is an investing phenomenon that can result in higher gains for investors during the first month of the year. The effect is thought to be the cause of individual investors selling stocks in December (to realize tax losses) and purchasing them back in January (thus driving up the share price).
Which investments or sectors are most susceptible to the January effect? Are there investments that suffer as a result?
Based on historical price movements, many believe small-cap stocks are most susceptible to the January effect. The most significant discomfort investors incur stems from thinking they can time the market and invest around the January effect.
Are there any risks to be aware of in attempting to leverage the January effect strategy?
The largest risk is that the January effect is a myth. A paper was published in 1988 describing the January effect. As a result, many investors started purchasing earlier, thus moving the January effect into more of a December effect. The historical returns since 1988 prove this result – for example, US small-cap stocks have performed better in December than compared to January.
To minimize the perception of risk, an investor can breakdown the amount he wants to invest into identical multiple tranches. Each tranche can be scheduled in advance and executed regardless of what is occurring in the markets. If the investor is a believer in the January effect (and pots of gold on the other side of rainbows), he can schedule two of his four tranches to occur in December and January. Thus, putting half of his money to work during the period where he thinks he can get the best deal.
For those, such as myself, that don’t believe in the January effect, there is still hope. The market is an efficient information-processing machine. Millions of market participants buy and sell securities every day, and the real-time information they bring helps set prices. Rather than basing an investment strategy on identifying securities that are priced ‘incorrectly’ from the January effect, investors should focus on building a thoughtful, well-diversified, high quality portfolio comprised of stocks and bonds of all sizes. As I’ve mentioned in previous posts, the most dominant determinant of long-term, real-life return is not investment performance, but investor behavior.
After finishing writing this post, I’m going to warm up a cup of hot chocolate and sit by the fireplace. That’s my real-life January effect!
Michael Tanney, December 20, 2018
Cover Photo: Brooke Lark (https://unsplash.com/photos/BRBjShcA8D4)