The New Year tends to be a time for optimism, including among investors. When share prices rise in January, analysts and financial commentators often call this the January Effect. But do stocks really perform better this month than in any other?
The January Effect is one of several seasonal "trends" we often read about when stocks follow certain perceived patterns. Others include the October Effect, the largely unfounded perception that crashes happen more often in October; and "Sell in May and go away", which refers to the perception of seasonally weaker stock performance between May and October.
While seasonal factors might once have had some impact on stock market performance, perhaps due to the greater importance of agriculture, it's inadvisable to use them as the basis for investment decisions in today's much more complex market.
What gave rise to the January Effect theory, and does it hold any validity? Analysts have attributed January stock market rallies to seasonal factors, such as investors selling losing stocks to offset capital gains in December, then rebuying them in January. Others claim the perceived January Effect is due to investors making New Year's resolutions to invest more, or using their year-end bonuses to purchase shares.
But there is little or no evidence that these factors lead to statistically significant outperformance of the S&P 500 Index of top US shares. For example, Investopedia found that in the 30 years since 1993, there have been 17 winning January months on the S&P 500 and 13 losing ones, making the odds of a gain only slightly higher than tossing a coin.
In fact, since the start of the 2009 bull market, January performance has been disappointing compared to other months. According to Investopedia, if investors want to understand short-term investment trends, they should focus on current market conditions rather than the calendar month.
However, there is a more discernible January Effect on smaller company shares (small caps) compared to larger ones. As small caps are less liquid, investors find it harder to trade them quickly, so anomalies caused by factors such as tax-loss harvesting are more likely to persist.
The 2024 Stock Trader's Almanac shows that the January Effect is still a clear trend in small caps, but it now lasts longer than one month. The outperformance of small caps against large caps currently starts in November, continues until mid-March, and is most prominent in the last half of December.
"With all the beaten-down stocks being dumped for tax-loss purposes, it generally pays to get a head start on the January Effect in mid-December," explains the Almanac. This means that the stock market's only "free lunch" happens just before Christmas.
It takes careful timing to profit from this effect, and even then it's a risky business. Unless you are a nimble professional investor, "time in the market, not timing the market" is a far safer and more successful approach. Setting long-term goals with your investment adviser and sticking to them is likely to deliver a much better outcome than trying to second-guess seasonal trends.
Greg Davies, Head of Behavioural Finance at financial technology provider Oxford Risk, says: "Even if the January Effect was an ultra-reliable trend, you should not base investment decisions on it. Stock markets go up in roughly 60 per cent of all months, and down in 40 per cent. So why gamble on one month? Also, no month or year is 'average'. You could get lucky, but it could go badly wrong. So timing the January Effect is playing against the house. Staying in the market is playing with the house."
Davies advises that it's best to invest into the stock market regularly throughout the year. "Stay invested at all times, and avoid trying to time your entry based on short-term news or spurious or unpredictable trends."
Unfortunately, most people find it hard to understand such statistical comparisons - we're worse at it than pigeons apparently. Nor are we generally disciplined enough to apply them even when we do understand. Instead, most people prefer to follow short-term narratives such as "markets are starting the year with a new wave of optimism".
To counter this irrationality, we should begin by understanding that everyone has their own investor personality and responds differently to market changes and short-term news. For example, some people are more anxious about investments than others, and some are more swayed by stories.
Building a good relationship with your financial adviser will let them understand your needs and personality, and see where you might need help with sticking to your long-term goals. "If you know you tend to make decisions based on short-term stories rather than statistical evidence, one way to counter this is to write a set of rules for yourself," Davies suggests.
Humans may not understand statistics very well, but we are good at following rules, so this pre-commitment prepares you emotionally for what may happen. One rule could govern when to invest, for example on a set day each month regardless of market conditions. Another rule could be to never make investment decisions during the week, but only at weekends after you've had time to reflect. Writing down these rules and adhering to them removes the burden of decisions and avoids emotional, knee-jerk responses.
This doesn't mean you shouldn't make a New Year's resolution to start investing in January. Davies says January is a useful month, after many holiday festivities are over and people have time to re-focus on sorting out their finances. Things to do could include:
Even if you only do these things once a year, it's better than never doing them at all. Now that's a January Effect worth having.
