January effect defines as the seasonal increase in the stock prices in the month of January. Many analysts believe that this increase in buying stock follows the drop in price, which usually happens in December. In December, usually, investors tend to sell out their stock since they do tax-loss harvesting to get their capital gain.
Or, the other possible reason for the January effect is that the investor uses their end-year bonuses to buy investment.
Basic Knowledge on January Effect
This effect brings more effect to small caps than to the mid-caps or large caps. That is because the mid and large caps are less liquid.
The hypothesis comes from data starting at the beginning of the 20th century. The data shows that many asset classes outperformed the overall market in January, the prices climb even higher toward the middle of the month.
The first person who has found this effect is Sidney Wachtel in 1942. Watchel was an investment banker. In recent years, however, this historical trend has become less pronounced.
Many analysts, especially since 2018, believe that the January effect is less important due to the more number of people who use tax-sheltered retirement plans. Thus, many people do not own reasons to sell their assets.
The Explanation behind the January Effect
Beside the harvesting and repurchases, investor purchases asset with their end-year bonuses, the January effect also has something to do with trading psychology.
Some traders keep believing that January is the best month to start an investment program. Many studies also find an increase in selling stocks during January due to many traders who have experienced capital losses at the end of the previous year.
Besides, many end year sell-offs usually also successfully attract buyers. On a large scale, this can also drive prices higher in January.