Have you ever heard of the January effect?

It is an anomaly in stock market returns, and one of the anomalies that have generated the most interest from experts in recent decades. The observed phenomenon is that small cap stocks have historically generated abnormally high returns in January.

Several hypotheses have been put forward to explain the January effect. Among the many explanations offered by the experts, the most plausible seems to be related to tax-loss selling in December.[1] We will go into more detail about that later.

It is essential to know that tax-loss selling can affect your portfolio near the end of the year. However, there are ways to position your portfolio to be somewhat protected and then to take advantage of the January effect.

 

What Are The Tax Considerations For Investors?

Let’s start with a quick overview of the primary tax considerations for investors who, like you and I, trade in taxable accounts.

When you buy a publicly-traded company, the price you pay becomes the cost basis against which you will compare your selling price to determine whether you have realized a gain or loss on the transaction. Sell ​​a stock for more than you paid, and you’ll make a profit. The opposite will produce a loss.

In Canada, in certain types of accounts such as TFSAs and RRSPs, the realization of gains or losses does not have any tax consequences. However, if you trade in taxable accounts, the gains and losses will have to be reported to the tax authorities, and you will pay taxes on the net capital gains.

The amount of net gains that will be subject to taxes is the sum of all realized gains minus the sum of realized losses. For example, if you make a $10,000 profit on one transaction but lose $4,000 on another, your net taxable gain will be $6,000.

A key point I want to bring to your attention is that the gains and losses must be realized, that is, you have to close the transaction. If you hold a stock for several years, your gains or losses will not be taken into account until you decide to sell.

Consequently, the moment when you decide to sell a stock is important. Beyond the fundamental considerations and the valuation of the company, your decision will also affect your tax bill at the end of the year.

Your goal should be to minimize the tax bill as much as it is possible and legal to do so. I am no tax expert, so please refer to your tax advisor or accountant to fully understand the implications of buying or selling securities in your situation.

For this article, what is essential to understand is that just like you, other investors are also trying to reduce their tax bill as much as they can. One of the most straightforward strategies to offset capital gains in a given year is to try and realize losses as well, by selling poorly performing stocks.

 

Tax-loss Selling

In general, investors start to think about these tax considerations towards the end of the year, in late November and December. At this time, they have a reasonably clear picture of the gains they realized during the year, as well as which stocks would be good candidates to sell at a loss.

It goes without saying that a stock sold at a loss is a stock that has declined relative to the original purchase price. It is usually a poorly performing stock, and there are probably many other investors also sitting on losses (on paper, at least).

Those stocks that performed poorly during the year generally tend to underperform even more in December, as shareholders sell to realize losses without any real considerations for the fundamentals of the business.

This wave of motivated sellers makes stock prices plunge at the end of the year, and even more so for small caps that have low transaction volumes. When the year comes to an end, and January arrives, this wave of sellers stops almost instantly, and the result can be a strong rebound in prices. December 2018 and January 2019 provide a great example of this concept.

According to many experts, tax-loss selling is the main reason behind the January effect anomaly. Following a period of underperformance in December, many stocks rebound in the first days of January, producing abnormally high returns.

 

So, How Do We Profit From It?

I identify two strategies to take advantage of tax-loss selling and the January effect. Before elaborating further, here they are in their purest form:

1) Sell before others

2) Buy when others sell

So it’s that simple? Well, almost. Let me tell you more.

 

Sell Before Others

This strategy has two components. On the one hand, it involves selling some of your stocks. It might mean selling at a loss to realize a tax loss yourself. If that’s the case, you might want to consider doing it before the chaos in December.

Another angle is to anticipate which stocks in your portfolio are likely to be affected by tax-loss selling and to reduce your exposure to those stocks that you consider more at risk. The ideal stock is one that has been in a downtrend for most of the year and for which you do not foresee a significant catalyst in the short term.

The second component, which is less apparent, is that the sale of some of your stocks will allow you to increase your cash position. Having cash is a crucial element in implementing the second strategy. Now that you have limited your losses, you want to have cash available to act when you see great buying opportunities.

 

Buy When Others Sell

If you have followed the first strategy, you will enter December with a sufficient cash position to take advantage of the upcoming bargains. You will, therefore, play an important role: providing liquidity to the motivated sellers who will attempt to sell their illiquid shares. And you will be rewarded handsomely for playing this role, getting considerable discounts in some cases.

To be prepared, it is crucial to determine which stocks could be offered at bargain prices. These may be stocks you already own and want more of. They can also be stocks on your watchlist – those that are currently too expensive by your criteria, but which you would be willing to buy at a lower price.

Try to identify the stocks that have performed poorly during the year. They are more likely to suffer in December. Observe them. Be on the lookout and act quickly when an opportunity arises. Your cash position will allow you to take advantage of these opportunities while others, fully invested, will have their hands tied.

If you buy smartly, you will find yourself in a better position to benefit from the January effect.

 

But Be Careful…

An anomaly like the January effect does not necessarily mean that there are opportunities to trade it profitably. As Richard H. Thaler notes in Economic Perspectives: “In the case of small firms, small trading volume and large bid-ask spreads militate against big profit opportunities.”[2]

Therefore, I do not recommend that you build your investment strategy around the January effect only. The reason why this anomaly persists is probably that there is no way for hedge funds to profitably invest a lot of capital and capture the profits (taking into account the low liquidity and transaction costs).

That said, the January effect is still a fascinating anomaly that deserves consideration. For a small retail investor, I think there is room to generate modest additional returns from this anomaly. At the very least, you can consider this as another piece of information in your decision-making process, even if it does not become an important criterion for you.

In the case of an investor who has little small cap exposure in his portfolio and who is looking to add some, the January effect would suggest buying in December rather than January. In such a situation, choosing the right timing can make a positive impact on returns.

What will your strategy be at the end of the year? Will you be a seller or a buyer in December?

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[1] Tax-Loss Selling and the January Effect: Evidence from Municipal Bond Closed-End Funds, https://undervaluedequity.com/tax-loss-selling-and-the-january-effect-evidence-from-municipal-bond-closed-end-funds/

[2] Anomalies – The January Effect, Richard H. Thaler, Economic Perspectives – Volume 1, Number 1 – Summer 1987 – Pages 197-201, https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.1.1.197