The January Effect is the Elvis of the investment management world. Some think it’s still alive (and working in a convenience store in Des Moines); others have buried it and moved on. It’s easy to see the confusion.
Our story begins in the mid-1970s, when a group of researchers found evidence of a seasonal tendency in the stock market using an equal-weighted average of New York Stock Exchange prices. According to the study, which used 75 years of data, returns for stocks in January were a staggering eight times higher than in other months. Intrigued, other academicians started tinkering. They eventually discovered that the effect was largely due to small stocks, which have greater influence in an equally weighted index like the one used in the study. The so-called January Effect trade, which involves buying small-cap stocks at year end and selling them a month later, was born.
The concept of small-cap stocks beating their larger rivals is nothing new. Most think it has to do with the nature of risk: Small stocks should return more, since such companies are less entrenched and have a higher probability of failure (this effect could be magnified at year end, a period where many investors dump losing stocks and buy them back in January to realize capital losses and lower their tax liabilities). But to find that nearly all the excess return from owning small-cap stocks occurs in just one month of the year–now that’s an anomaly.
Investors with a “show me the money” attitude toward such market predilections may be in for a disappointment, as the January Effect seems to have lost its luster in recent years (see chart below). There are several potential reasons why. For starters, some feel that the benefit of owning small caps goes away when transaction costs are considered. Others feel there are data “snooping” issues, a fancy way of saying that re- searchers may have inadvertently analyzed time periods where small caps did well, while ignoring all others.