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, is a phenomenon in which (small) stock prices tend to increase during the month of January. It was first documented by investment banker Sidney B. Wachtel, who studied seasonality in the Dow Jones index from 1927 to 1942 and found that (small) stocks 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 a report titled “Tax-Loss Selling and the January Effect” by Laura T. Starks, Li Yong, and Lu Zheng (2006), the year-end tax-loss selling behavior of investors accounts for a large proportion of the January effect. They also found that closed-end funds associated with brokerage firms display more tax-loss selling behavior.

Note: Investors should be cautious about drawing conclusions regarding insider trading activity that takes place in (late) December due to the January effect.