Human beings are hard-wired to be pattern-seeking and our brains usually struggle to put order to the chaos around us. It is no different when it comes to the stock market as it is a complex adaptive system which has confounded even the smartest brains.
A complex adaptive system is one which has numerous inputs and variables that influences the system’s outcome in random, unpredictable ways. A prime example of such a system would be the weather, which most forecasters are unable to forecast with pinpoint accuracy.
Many different phenomena have been observed in the stock market, some of which supposedly occur with strange regularity. One of these is the “January Effect,” which is a supposed tendency for stock prices to move higher in the first month of a year. So what is this effect and how can it be explained?
The January Effect
Many market observers had noticed that stock prices in general tend to move up during January, and over time, this has been termed the January Effect. A behavioural finance study by Tilburg University on the effect mentions that it was first noticed by a pair of researchers, Rozeff and Kinney, in 1976.
The researchers found seasonal patterns when evaluating an equal-weighted index of stocks on the New York Stock Exchange over the period 1904-1974 (70 years). They discovered that the average monthly return for January was 3.5%, versus just 0.5% for other months. So, the higher return in January does seem to provide evidence that the January Effect exists.
However, do note that the January Effect was NOT observed in an index which consisted only of large firms – I shall comment on this important finding later in this article.
Why the effect exists
Even the famous economist and author Richard H. Thaler had investigated the January Effect in a paper he wrote in 1987. The conclusion was that there did not seem to be any definite attributable factors in determining the reasons for the pervasive phenomenon of a higher return in January. Some suggestions have included fund managers buying back shares after selling them in December for tax-related reasons, as well as retail investors increasing their purchases of shares after receiving their year-end bonuses in January.
I admit that the above may be plausible reasons for this effect, but I would like to further point out that this effect is conspicuously absent when the index contains only of companies with large market capitalisations. This implies that the effect may be due to the presence of smaller companies which are bought up by investors at the start of the year, and that the lower valuations and depressed share prices may result in a larger effect when this buying occurs, as compared to the blue chip companies.
A Foolish conclusion
My conclusion is that the January Effect does exist, and it has been documented often by many researchers. But everyone is divided over the exact reasons for it occurring.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.