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Thursday, 26 June 2014

J is for January Effect

The January Effect  is the observation that small cap stocks consistently outperform markets in January. It's one of a number of calendar related anomalies that suggest there's a peculiar interaction between people, markets, tax regimes and the environment. You can take the investor out of their natural environment, but you can't take the natural environment out of the investor.

Example

The January effect is a well established phenomenon for which there is no satisfactory explanation: small cap stocks go up more than they should in January. There are lots of other seasonal effects - the old adage "Sell in May and go away" seems to have more than an whiff of truth about it, for instance. And seasonal effects can have bizarre results - one study shows that lucky people tend to be born in the Spring and Summer. Ridiculous? Well, maybe. But summer babies are wrapped up less and get more opportunity to explore; and early development can have major cognitive impacts in later life.

Causes

Various efforts to explain the January effect have involved people trading around the end of the tax year to maximize use of tax allowances or various, convoluted, risk-based explanations, but there's no agreement whatsoever. However, it is one of a number of seasonal effects which potentially seem to have  links to weather variation and sunlight - Seasonal Affective Disorder (SAD) is implicated in a number of studies which are robust across both Northern and Southern hemispheres where the summer and winter months are reversed.

Mitigation

If you're affected by SAD you probably need to take the appropriate countermeasures. More broadly, if a significant subset of market participants are being swayed by seasonal effects this will have a knock-on impact on the whole market through herding and self-enhanced transmission bias. Short-term momentum investors should embrace these trends with joy, but the rest of us should make sure we're not part of the herd stampeding towards the abyss. There's nothing like finding yourself upside down in a hole with a heifer on your head to make you re-assess your investing strategy.

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