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Historically, the month of January has shown abnormally high stock returns for stocks with small capitalizations. The effect is so large in fact that the return of a security in January may be the largest portion of its annual return. Several reasons have been hypothesized for The , but the most popular reason for The January Effect is tax reduction tax-loss selling.
The "tax-loss selling/January Effect" relationship has been heavily investigated and is hypothesized to be due to investors selling "loser" stocks primarily at the end of the year in order to realize tax reduction advantages. In order to realize a tax reduction tax-loss, investors must sell "loser" stocks prior to end of the tax year. The stocks then become abnormally depressed due to the tax-loss selling and then return to their equilibrium level in January causing abnormally high returns in January. Additionally, after the Tax Reform Act of 1986, a "tax-loss/November Effect" has also been observed and investigated. The hypothesized reason for the November Effect is proposed to be due to:
The January Effect Background
- The tax year-end for mutual funds is Oct. 31 instead of Dec. 31, and
- Capital gains preferential treatment removal.
A significant amount of effort has been expended researching The . Several reasons have been hypothesized for this effect: portfolio rebalancing, intergenerational transfer, short-sellers closing out positions and tax-loss selling. The occurrence of The January Effect has been documented in many countries including: US, Belgium, Canada, Denmark, Germany, Japan, Netherlands, Norway, Spain, Sweden, Switzerland, Hong Kong, Singapore and Malaysia. Interestingly, The January Effect has not been observed in the Philippines or in Australia; however, in Italy, Belgium and the Netherlands the return from The January Effect is larger than the average return for the entire year.
Some studies claim to support the "tax-loss selling/January" connection and conversely some studies also claim not to support the connection between tax reduction tax-loss selling and The January Effect. Studies investigating tax-loss selling prior to and after the War Revenue Act of 1917 when the income tax was instituted have both claimed to have supported and not supported the connection between tax reduction tax-loss selling and The January Effect. One study investigating tax reduction tax-loss selling in Britain, which has an individual tax year end for individuals in April instead of the US's January, indicated that a potential tax effect does appear to influence the London Stock Exchange. Overall, the general consensus of researchers is that The January Effect appears to be at least partially and maybe primarily driven by individual investors tax reduction tax-loss selling whereas the November Effect may be due to mutual fund tax reduction tax-loss selling.
The January Effect and Market Efficiency
The market efficient hypothesis is not consistent with a The caused by any the hypothesized reasons: tax-loss selling intergenerational transfer, short-covering and/or portfolio rebalancing. The efficient market hypothesis argues that in the event securities are oversold due to tax-loss selling, etc. , buyers would recognize the securities as being undervalued and would take advantage of the undervalue situation and acquire the securities. The market efficiency hypothesis would also argue that as more investors became aware of The January Effect, they would anticipate the effect and as a result would purchase securities fitting the profile for The January Effect and by doing so would thereby negate The January Effect.
The January Effect and Behavioral Finance
A rational investor holding a "loser" stock would not wait until the end of the fiscal tax year to sell the "stock" in his/her personal stock portfolio, but rather would sell the stock when the fundamental elements were such that the stock was overpriced. However, an investor subject to behavioral cognitive or find no rx purim
emotional biases, a normal investor, would not want to sell the stock in his/her personal due to regret aversion, but would rather wait until the last moment to sell the stock, in the hopes that the stock might recover. Elements of self-control are also at play in this process, because the tax year-end acts as an overriding mechanism to force the investor to realize the losses for tax purposes. The investor is attempting to avoid regret by waiting until the very last moment to sell "losers" for tax reasons. The normal investor has thus framed his assets into "winners" and "losers" and refrains from selling the "losers" earlier due to regret aversion and/or lack of self-control. The research with respect to The January Effect seems to validate the normal investor's selling stocks to take advantage of tax reduction tax-loss as opposed to the rational investor's selling when the stock is overpriced.
In the instance of portfolio managers window dressing their portfolios, they have also framed their portfolio's assets into "winners" and "losers" and it is hypothesized that they sell their "losers" at the end of the tax year and purchase "winners" with the funds generated from selling the "losers", hoping to increase the attractiveness of their portfolios by having more "winners" in the portfolio than previously. In order to avoid feelings of regret, the portfolio managers wait until the very last instance to sell the "losers". [find no rx purim
] This short-term view with respect to their portfolio's returns is most likely due to regret aversion due to wanting to retain current customers and attract new customers by "hiding" their true performance and is most likely negatively impacting the long-term return of their portfolios, since recent past "losers" are more likely than recent past "winners" to outperform in the near future.
The moral of the story is that a prudent investor would recognize the cognitive and emotional bias pitfalls of tax-loss selling and would "sell" loser stocks sooner in order to avoid selling at drastically reduced prices caused by the normal investors all waiting until the last moment to sell their "loser" stocks. A prudent investor might also recognize and take advantage of the normal investor's tax-loss selling behavior by buying the appropriate securities fitting the tax-loss profile at the optimum moment in time.
The moral for portfolio managers would be to recognize the cognitive and emotional bias errors with respect to window dressing and refrain from the practice. The portfolio managers might actually be more prudent by selling the "winners" and buying the "losers" instead of vice-versa.
The exists, is a reality for the stocks of small capitalization companies and is not consistent with the market efficiency hypothesis. The January Effect appears to be at least partially a result of year-end tax reduction tax-loss selling and may potentially be due to window dressing by portfolio managers. In the event The January Effect is a result of year-end tax-loss selling, it is proposed that a normal investor has framed his assets into "winners" and "losers" and refrains from selling the "losers" earlier due to regret aversion and/or lack of self-control. The looming tax year-end then acts as an overriding mechanism for overcoming a lack of self-control to force the investor to realize losses for tax reduction purposes. Find no rx purim
in the event the january effect is a result of portfolio managers window dressing their portfolios, they have also framed their portfolio's assets into "winners" and "losers" and it is hypothesized that they sell their "losers" at the end of the tax year and purchase "winners" with the funds generated from selling the "losers" find no rx purim
, hoping to increase the attractiveness of their portfolios by having more "winners" in the portfolio than previously. This short-term view with respect to their portfolio's returns is most likely due to regret aversion due to wanting to retain current customers and attract new customers by "hiding" their true performance.
[tags]The January Effect, tax reduction, Tax-Loss Selling, Portfolio Rebalancing[/tags] ?? 2008-2016 Legit Express Chemist.