The world of finance and investments is notorious for its extensive use of jargon. With a goal of enhancing financial literacy and making the world of money more transparent, we have our “monthly jargon” posts that focus on debunking financial terms that are often used sans explanation. This month, we are addressing a term that is fitting to dive into during this first month of the year: the “January Effect.” Over the years, analysts and traders have taken note of the recurring tendencies they see in the markets at certain times and months each year. One of these observations that have been noticed to occur at the beginning of every new year is known as the January Effect. Put simply, the January Effect is an apparent, reoccurring increase in stock prices throughout the month of January. This annual trend is typically attributed to an increase in investors buying stocks and reinvesting funds in the new year following the usual selling trends in December that involve investors taking advantage of tax-loss harvesting strategies that often result in a bit of a sell-off before year-end. People also attribute the January Effect to investors putting more cash into the markets after receiving their year-end bonuses and annual salary bumps.
Investor psychology has also been used as an explanation for the January Effect, as the first month of the year innately serves as a perfect time to kick off the new year with investment initiatives and goals that involve New Year’s resolutions to save and invest more. Additionally, the small sell-offs that often occur at year-end via tax-loss harvesting tend to drive stock prices lower going into the new year, and these lower prices also trigger investors’ minds to think about buying into the markets at these more attractive prices.
To back up all of these theories, when you take a look at historical market data, you will see that the January Effect does prove to be true more often than not. Since the S&P 500’s inception in 1928, the index has finished January up in the green 68% of the time. Furthermore, when stocks have finished the first five trading days of the new year in the green, the S&P 500 has finished the year positive 82% of the time with an average gain of 13.6%. This concept is known as the “First Five Days” rule and goes in tandem with the January Effect as a potential indicator of how the markets will perform for the year as a whole. Overall, historical returns have shown that buying in January and holding through the end of the month and even the end of the year tends to yield positive returns. Remember that despite this data, there are always outliers, and the January Effect is only a theory based on historical performance and is not an assertion of what every January will bring.
All in all, the January Effect speaks to the fact that, given the market’s history, we tend to see broad-market stock indexes close out the month of January higher than they opened the month. However, remember that this is a simple market theory and not a certainty. There are many variables that bring potential risk to the markets that can derail this concept in any given year; for example, the trade war with China, global economic growth, and politics both domestically and internationally, to name a few that we are facing at the moment. It’s prudent to take market theories like the January Effect with a grain of salt and ensure you evaluate any other potential factors before making investment decisions.
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