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The mythical January Effect

Every year at this time comes the discussion of whether stocks are a good buy in January. The so-called January Effect describes a hypothesis that stocks go up at the beginning of the year because investors want to start buying again, possibly as a result of tax-related sales in December.

This effect considers that small-cap stocks are most likely to see a boost, as they are owned by a higher proportion of individual retail investors. These investors supposedly are more likely to be selling in December and buying again in January.

Much research has gone into proving whether or not the January Effect is real. Or whether it's predictable. Or whether it's worth the trading costs associated with it. Or whether the effect already starts in December because everybody knows it's coming in January anyway.

Going back to the 1980s, small caps have tended to outperform large-cap stocks. The Russell 2000 index represents small-cap stocks. The S&P 500 can give you better median returns, but the average (mean) return is lower for large caps. The risk-adjusted return (as noted by the Sharpe ratio) is better for small-caps, but the S&P 500 saw a higher proportion of positive returns overall.

In other words, one set of stocks isn't necessarily better than the other.

But how does January stack up against the rest of the year? Quite pedestrian, actually:

The average returns by month show that January isn't unique in any way, with truly average performance. Notice all three months in the fourth quarter beat out January.

Most of January's gain's actually occurred in the '80s and '90s. Since 2000, it's almost a coin flip whether the month will be positive or negative.

As these charts show, the data on January shows it's not a special month. Beware of anybody who suggests otherwise.