January Effect – How Do Tax Loss Selling and Window Dressing Effect Your Stock Prices

The January effect, also known as the turn-of-the-year effect, refers to the general increase in (small) stock prices during the month of January.

The investment banker Sidney B. Wachtel was the first to examine and document seasonality in the Dow Jones index from 1927 to 1942 in his paper Certain Observations on Seasonal Movements in Stock Prices. He observed that (small) stocks have outperformed the broader market from December to January in eleven of the fifteen years he studied. Most of this disparity occurred before the middle of the month.

There are two main hypotheses to explain this phenomenon:

  1. Tax-loss selling – In (late) December investors sell stocks in which they have losses in order to lower their taxes on net capital gains, thereby further increasing the downward price pressure of losing stocks. In January the proceeds from these sales will be reinvested, resulting in large January returns.
  2. Window dressing – In (late) December portfolio managers sell losing and risky stocks and hold cash and blue-chip stocks instead to make their year-end portfolios appear more conservative. In January the proceeds from these sales will be reinvested, resulting in large January returns.

According to the report: Tax-Loss Selling and the January Effect from Laura T. Starks, Li Yong and Lu Zheng (2006) they find evidence that the year-end tax-loss selling behavior of investors accounts for a large proportion of the January effect. In addition, they find that closed-end funds associated with brokerage firms display more tax-loss selling behavior.

Note: Due to the January effect I recommend you to be cautious to draw conclusions about the insider trading activity which takes place in (late) December.

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