The January Effect: Ignore this investing advice

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Millennials, this is how you can fix your YOLO financial mind-set.
USA TODAY

The January Effect used to be a reliable way for traders to turn a quick buck between late December and early January. But, on Wall Street at least, all good things come to an end.

In fact, this famous year-end pattern stopped working some 15 years ago. Old beliefs die hard, however, and many brokers continue to urge clients to trade based on it.

Gee, do you think brokers are letting their judgment be colored by the desire to earn commission income?

The January Effect refers to the tendency of stocks of the smallest companies to outperform those of the largest firms over the last part of December and the first part of January. Though traders over the years have used different dates for entering and exiting the trade, one popular approach several decades ago was to initiate it on Dec. 20 and close it on Jan. 9.

Consider the track record of a hedging strategy that for this three-week period invested in a basket of small caps, as represented by the Russell 2000 index, while simultaneously selling short an equal dollar amount of large-cap stocks, as represented by the Standard Poor’s 500 index. Selling a stock short, of course, is a bet that its price will decline. This hedge makes money to the extent small caps outperform large caps and even turns a profit when the stock market as a whole is falling — so long as the small caps don’t decline as much as the large-cap stocks.

While this strategy didn’t always work in the 1980s and early 1990s, it did more often than not. Its gain averaged between three and four percentage points per year. These returns might not initially strike you as all that noteworthy, but in fact they are quite impressive for just a three-week holding period.

Since the late 1990s, however, the strategy’s profitability has been steadily declining. Over the last 15 years, on average it has produced a 0.5-percentage-point loss.

What caused the strategy’s deterioration and eventual disappearance? No one knows for sure, since researchers never found conclusive evidence of why it existed in the first place. One of the best-known academic analyses of the January Effect, for example, called it “The Stock Market’s Unsolved Mystery.”

The most likely culprit, however, is that the strategy became too popular, since that can kill the goose that lays the golden egg. After all, if enough investors know that small-cap stocks will perform well in late December and early January, they will try to get a jump-start on other traders by investing in them prior to late December. That in turn pushes their prices up and reduces or eliminates the gains that otherwise could be realized from the strategy.

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The broader moral of this story is that if something seems too good to be true it probably is. It’s not that there aren’t patterns in the stock market that we can exploit for a profit. The problem is that we’re competing with thousands of Wall Street analysts who, armed with their super computers, spend full time scouring the historical record to find — and profit from — such patterns. The chances of any of us finding those patterns before they do are close to zero.

The late Harry Browne, the former investment newsletter editor and one-time Libertarian Party candidate for President, constantly reminded us that, “Almost nothing turns out as expected … Investment advisers with records of phenomenal success fail to deliver when your money is on the line.”

In fact, his reminder would be a good New Year’s resolution for all investors to remember.

Mark Hulbert, founder of the Hulbert Financial Digest, has been tracking investment advisers’ performances for four decades. For more information, email him at mark@hulbertratings.com or go to www.hulbertratings.com.

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