Is there a better time to invest than others? Some theories believe so. One example is the Santa Claus Rally, which suggests that the weeks around Christmas are the best. However, there are also reasons to believe that January is the best month to invest, a theory known as the January Effect. But how reliable is it today? In this article from Hapi, we explain what the January Effect is, how it originated, and what could happen this January.

What is the January Effect?

The January Effect refers to the bullish trend typically seen in the U.S. stock market during the month of January. However, not everyone trusts this hypothesis. Some analysts believe that this stock market rise is not very significant.

Despite this, many traders take this effect into account for their strategy. They buy stocks at the beginning of January at a low price and sell them toward the end of the month for a profit. This effect occurs particularly for small-cap stocks, or companies with lower market capitalization.

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The History of the January Effect

Since the beginning of the 20th century, data has shown that January has been particularly good for small publicly-traded companies. The first to notice this was investment banker Sidney Wachtel.

In 2005, two researchers from the University of Kansas published a research paper studying stock data from 1802 to 2004. They found that small-cap stocks typically outperformed the general market in January. Additionally, they found that stocks with strong momentum (i.e., those that had been on an upward trend recently) tended to have lower returns during this month.

In fact, when looking at the period between 1941 and 2003, January had the best absolute returns compared to all other months of the year.

However, now that this trend has gained popularity, its effect has almost completely disappeared. In the last 30 years of the S&P 500, only 57% of January months have been positive, and 43% negative, making the probability similar to a coin toss.

Why did the January Effect occur?

The theory suggests that during the last months of the year, large investment funds and investors sell off certain stocks at a loss to reduce their overall tax bill (on capital gains). Then, in January, they repurchase these stocks at a lower or similar price, saving on tax expenses. This practice is known as tax-loss harvesting.

Another reason for this effect could be that end-of-year cash bonuses are invested in the stock market in January.

There’s also a psychological explanation for this kind of market movement. Some investors consider January the best month to start an investment plan, or they do it as part of their New Year's resolutions. These increases in trading volume drive stock prices up.

The January Effect and Efficient Market Theory

A useful concept to understand why this effect has lost relevance is efficient market theory, which holds that stock prices reflect all available information to investors.

In that sense, since all market participants have access to the same information, it’s not possible to outperform the market by buying individual stocks or investing during specific periods.

As more investors became aware of the January Effect, markets adjusted to prevent anyone from capitalizing on it.

How to Invest During January 2023

In summary, January is believed to be a good month for investors, especially those holding small-cap stocks.

However, the evidence supporting this theory is quite limited, so investors shouldn’t rely on January being a positive month. Ultimately, calendar-based theories like the Santa Claus Rally and the January Effect are just that: theories. No one knows for sure why they occur or if they will occur again.

For this reason, in 2023, it’s better to base investment decisions on broader factors, such as the overall performance of the stock market over the past few decades. If you want to participate in the financial markets and invest from Latin America, download Hapi. This app lets you invest in stocks and cryptocurrencies without commissions, from your phone, throughout the entire year. Start here now!