The January Effect

Analysis of broad samples of value-weighted and equal-weighted returns of U.S. equities documents that abnormally high rates of return on small-capitalization stocks continue to be observed during the month of January. This January effect in small-cap stock returns is remarkably consistent over time and does not appear to have been affected by passage of the Tax Reform Act of 1986. This finding brings new perspective to the tax-loss selling hypothesis and suggests that behavioral explanations are relevant to the January effect. After a generation of intensive study, the January effect continues to present a serious challenge to the efficient market hypothesis.Using 1802–2004 value-weighted data and 1927–2004 equal-weighted data, we update evidence on the January effect in stock returns. We found a persistent January effect for small-capitalization stocks. We also document that the anomalous pattern in monthly returns exists by using portfolios based on size and book-to-market factors. Both size and book-to-market effects appear to be at work in the January effect, but size effects predominate. We also found a persistently negative January effect for momentum stocks. The observation of a January effect primarily for small-cap stocks supports others’ findings of an abrupt switch to net buying of small-cap stocks by individual investors in January.We found the January effect to exist for small-cap stocks even in the period following passage of the Tax Reform Act of 1986. The Tax Reform Act required mutual funds to distribute at least 98 percent of realized capital gains and dividend income generated during the 12-month period ending 31 October. So, since 1986, net capital gains distributions to mutual fund shareholders have been determined without regard to capital losses attributable to transactions occurring during the last two months of the calendar year. Those capital losses are carried over to the subsequent tax year. Any seasonal tendencies related to tax-motivated selling by institutional investors after 1986, therefore, should occur well before the end of the calendar year. Although tax effects have long been offered as a plausible explanation for a January effect in the United States, the continuing presence of a January effect since 1987 appears to weaken that argument.Because we found that the January effect remains largely a small-cap phenomenon, and one that has been unaffected by the Tax Reform Act of 1986, our findings offer support for behavioral explanations of the January effect that are tied to the anomalous buying and selling behavior of individual investors at the turn of the year. Because many institutions retain a January–December reporting period despite the new November–October tax period, “window dressing” by institutions to improve reports to clients may be contributing to the January effect in the post-1986 period. Tax-motivated selling by individual investors at the turn of the year also remains a plausible explanation.In any event, we conclude that the January effect is a real and continuing anomaly in small-cap stock returns, and one that defies easy explanation more than 30 years after its discovery.