The January Effect
I hope you enjoyed a joyous holiday spent with family (whether in person or virtually). 2020 was certainly a weird one, and a New Year is on the horizon.
Every January a few things happen. Mostly they involve new workout routines, innovative diet plans, a commitment to self-improvement, and an optimistic outlook on the year ahead.
While most of us fret about dropping a few pounds, eating healthier or finally finishing that novel, seasoned investors have another goal in mind: they spend December and January of every year with an eye on taxes.
On December 31st one tax year ends, and on January 1st another one begins. That simple rule has led to a market-wide theory called: The January Effect.
What Is the January Effect?
The January Effect is a perceived seasonal increase in stock prices during the month of January. Studies attribute this to an increase in buying, and this can occur for a number of reasons that we will explore below:
Each December seems to be a strategic time for portfolio managers and investors alike to evaluate their holdings and sell off any positions that are under water (down from their actual cost base). Selling an investment at a loss may seem like a bad idea, but this isn’t always the case from a tax perspective.
Here is an example:
You own 3 stocks in your portfolio; Stock A, Stock B, and Stock C. Each stock was purchased for $10,000 and are currently trading at:
Stock A market value = $12,500
Stock B market value = $36,000
Stock C market value = $2,000
A few things are at play here; primarily that no taxes or gains/losses are incurred until they are sold.
With that in mind, you decide to exercise “tax-loss harvesting” and sell all of Stock C. Here are the implications:
You realize a capital LOSS of $8,000 ($10,000 purchase sold for $2,000).
This $8,000 loss can either:
Be applied to past gains that you already paid taxes on up to 3 years into the past. This means you can recoup past taxes!
Be applied to present gains in your portfolio, thus reducing the amount of gains to pay taxes on this year.
Can be kept in your back pocket (like a “get out of jail free” card in Monopoly) going forward indefinitely to be applied against any future gains – for example, whenever you decide to sell some or all of Stock B in the future.
Another consideration: if you truly believe in the recovery of Stock C and as a result, you don’t feel like it’s a good idea to sell it at a low valuation, you can either:
Buy it back 30 days after you sell it. If you sell it and buy it back right away, you do not get to use the loss.
Buy something similar or in the same industry; something that will also participate in a recovery.
Back to the January Effect
Tax-loss harvesting involves selling the “losers” to harvest the losses for the reasons explained above. This selling in December can bring stock valuations lower, and the resulting “buying back” of these losers causes the markets to increase in January.
Other possible explanations for the increase in buying in January include:
Investors using year-end cash bonuses to purchase investments the following month.
Investors believing that January is the best month to begin an investment program, or perhaps are following through on a New Year's resolution to begin investing for the future.
Active portfolio managers (like mutual fund managers) purchasing top performing stocks at the end of the year and eliminating questionable losers; all for appearance sake in the year-end reports, an activity known as "window dressing."
Year-end sell-offs also attract buyers interested in lower prices. On a large scale, this can drive buying in January.
The January Effect is hotly debated
Calendar-based fluctuations are a sign of an inefficient market. They involve people buying and selling stocks not based on the value of the underlying companies but because of external concerns.
Efficient market theorists argue that modern markets work too efficiently for the January Effect to significantly affect trading because investors would anticipate the January effect and would buy stocks as other investors offloaded them in December, anticipating the rise in January, and would price this into their trades up front.
The truth seems to be somewhere in the middle. The January Effect no longer appears as pronounced as it was in the mid-20th century when it was first documented. However, some data still supports the idea of a December/January fluctuation to a certain degree.
The take-home here is to ensure you have a framework for long-term investing, and to ensure your emotions (excitement when markets are up, fear when markets are down) don’t cloud your judgment in sticking to that framework.
If you have any questions about your financial plan, would like our opinion on what this current financial landscape means for long-term investors, or would like a refresh on the framework we have in place for times like these, please never hesitate to reach out.
We are available and accessible to you any time through email, phone, or teleconference (video).
Be well and be safe,