The January Effect hypothesizes that there is a seasonal increase, or an anomaly in stock prices during the month of January. Basically, its a pattern displayed by stocks, in particular small-caps stocks, wherein they show a tendency to rise during the last days in December and then carry on rallying throughout the first week of January.
There are various theories put forward to explain why the January Effect takes place. One is that mutual fund managers will go shopping at the end of December, to purchase stocks that have impressed significantly throughout the year. A drill they call “window dressing”. Holdings are displayed in the mutual fund’s Yearly Report, presented to the shareholders. It looks nice to be holding a portfolio full of “winners”. Demand from these investors can many times cause prices to rise. Also, due to the year end approaching , many investors sell shares of ill-performing stocks. A few are looking to break their ties to worst investments for the purpose of having a rejuvenated start to next year. However, mostly, the year-end selling is due to attempts to recoup tax losses. Investors sell off their losers to realize the capital losses that may be utilized to offset capital gains elsewhere. As the new year starts, returns gained from these sales are frequently redeployed back in the financial market, thus increasing stock prices. The theory may also be related to the psychology of the investors involved. To many people, commencement of the first month of the new year is a fruitful period to investment.
The January Effect’ was first ascertained by investment banker Sidney Wachtel in 1942. He discovered that since the year 1925, small stocks had performed better than larger ones in the month of January. Most of the effect happened in the in the initial weeks, just before the mid-January time period.
In order to act on the January Effect, one would invest directly in small-cap stocks at the beginning of each and every January. Then they would buy large-cap stocks for the remaining part of the year.
At the outset, it may seem that 'January Effect' is an ideal trend to realize outsized gains in the stock market. However, in recent years its been quite hard for investors to fetch profits from this strategy. The anomaly has been less and less pronounced. Therefore, one should not solely depend on the January Effect. However, one should not completely shy away from this phenomenon. The January Effect has historically helped investors reap gains from the stock market.