Exploiting ‘January Effect’ Means Taking Some Risks

Nothing is a sure thing in the stock market. But one investment pattern that has been pretty dependable over the years is the so-called January effect, although taking advantage of it may be trickier this year.

The effect is the tendency of small-company stocks to outperform big-company stocks in January, due to year-end tactics of money managers and tax-loss selling. Investors buying small stocks in mid- to late-December and selling them a month later profited nicely last year and in other recent years.

Evidence of the effect is dramatic. Between 1935 and 1986, stocks of the smallest 20% of companies on the New York Stock Exchange outperformed the largest 20% by an average of 8.08 percentage points each January, notes Robert A. Haugen, a UC Riverside finance professor and author of the book, “The Incredible January Effect.” Small stocks’ advantage over big stocks amounted to a mere 0.07 percentage points the other 11 months.

(In fact, Haugen argues, January has over time proved to be the best month for all stocks.)

What causes the January effect? No one knows for sure, but Haugen believes that it is largely due to behavior of institutional money managers, who are rewarded for beating the Standard & Poor’s 500-stock index of larger-company issues.

As year-end approaches and money managers must show their annual performance, they sell small-company stocks, either to lock in gains versus the S&P; 500 or to cut losses, Haugen says. That depresses prices of small stocks in December. Then, as the new year starts in January, managers buy small stocks they think most likely to beat the S&P; 500, boosting prices.

Another reason for the effect: year-end selling of stocks by investors wanting to realize capital losses for tax purposes. Such losses offset capital gains so that those gains won’t be taxable as income.

Should you try to play the January effect?

Perhaps, but be forewarned that it’s not risk-free.

First, even if small stocks outperform big stocks, you won’t make money if the overall market goes down. In that case, small stocks will simply lose less than big stocks. In Januaries between 1871 and 1987, the market rose 72 times, fell 41 times and stayed flat four times, Haugen notes. Many stock experts say the market is due for a correction as new post-crash highs have been set with low trading volume and very little investor enthusiasm.

Second, as the effect has become more widely known and exploited, investors increasingly try to play it earlier. As a result, the effect seems to begin in mid-December--meaning that you may need to buy in early December.

Last January, for example, the NASDAQ index of over-the-counter stocks--a good proxy for small stocks--rose 4.3%, only matching the S&P; 500. But between Dec. 15, 1987, and Jan. 15, 1988, the NASDAQ gained 8.8% versus only a 4.1% gain for the S&P; 500.

“Call it the December effect,” says David Warnock, executive vice president of T. Rowe Price New Horizons Fund, a small-stock mutual fund.

Warnock, however, thinks that growing investor attempts to capitalize on the January effect will eventually kill it.

“Ultimately it will get discounted out of the market,” Warnock argues. “When an opportunity pops up consistently for several years, people arbitrage that out. That’s why the January effect has moved into December. People started buying these stocks earlier.”

Haugen disagrees. Experts have been predicting the demise of the January effect for some time--yet it endures like Old Faithful, he argues.

“Something this big that’s been around for this long is not likely to go away in the course of a few years,” he says. “The forces behind it are so powerful,” involving thousands of money managers.

In any event, if you decide to play the January effect, fund manager Warnock suggests buying technology stocks, since they tend to have the most “pop” in January.

Some brokers or newsletters may be more than happy to help in selecting the right stocks. For example, Market Logic, a Ft. Lauderdale, Fla., newsletter (800-327-6720), recommends January-effect stocks.

But buying small stocks on an individual basis can be time-consuming and costly, particularly now as trading volume in these shares has tumbled markedly in recent months and thus you may have to pay your broker higher transaction costs.

“Whatever you buy you better be darn sure about, because if you want to sell there’s no market,” says Charles Allmon, editor and publisher of Growth Stock Outlook, a Chevy Chase, Md., newsletter.

Your best bet may be through a no-load mutual fund investing in small stocks. (A no-load fund charges no sales commissions.) And buying a mutual fund rather than individual stocks will give you more diversification.

Don Phillips, editor of Mutual Fund Values, a Chicago-based investment advisory service, says strong performing no-load small-stock funds suitable for playing the January effect include Vanguard Index: Extended Market Portfolio (800-662-7447), 20th Century Vista (800-345-2021), Babson Enterprise (800-422-2766) and T. Rowe Price New Horizons (800-638-5660).

Suitable load funds, he says, include Over-the-Counter Securities (800-523-2578), Royce Fund-Value (800-221-4268), Fidelity OTC (800-544-6666) and Putnam Emerging OTC Growth (800-225-1581). Phillips warns, however, that front- or back-end sales charges become a drag if you’re investing only on a short-term basis.

Also, he adds, fund companies generally discourage investors from moving in and out of funds in short periods. But if you don’t overdo it, most funds won’t question you, he says.