Every year, investors come into the new year with enthusiasm about their prospects for generating strong returns on their portfolios. Yet especially for those who don't have a ton of experience with investing, it's all too easy to fall prey to common misconceptions about how the stock market works -- and those mistakes can be costly.
One topic that comes up at the beginning of every year is the January effect. This market timing indicator focuses on the performance of the stock market during the early part of the year, the idea being that a favorable start necessarily means the entire year will go well, while a poor showing early on points to future weakness. That might sound unlikely on its face -- beyond the simple fact that after a big move, it's more difficult for the market to reverse direction than to stay where it is or keep moving in the same direction. However, there are some reasonable-sounding rationales for the January effect. Below, we'll look more closely at them, and then judge the performance of the indicator over the past decade to see how it's done.
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What exactly is the January effect?
One problem with the January effect is that not everyone agrees on exactly what it's measuring. One version of the January effect refers to the first week or so of trading in the stock market. Proponents of this version argue that many investors will have sold off their stocks to harvest tax losses late in the previous year, and that can artificially depress share prices for a time. At the beginning of the following year, that pressure comes to an end, because it's too late to claim tax losses for the previous year. As a result, bargain-hunting investors jump in and pick up shares of those beaten-down stocks on the cheap.
Other investors prefer to look at the entire month of January before concluding whether it'll be a good or bad year for the market. The idea is that momentum-based investors often reset their expectations at the beginning of a year and then look for signs of how the immediate future will go. A good start can build positive momentum, but a bad start raises fears that can lead to self-fulfilling prophecies among bearish investors.
The mixed performance of the January effect
Unfortunately for its proponents, the January effect has had pretty bad performance when you look back at the last decade in the stock market. The following uses the S&P 500 to determine whether the January effect successfully predicted the direction of the market for the entire year.
With four correct and six incorrect calls in the past 10 years, predictions based on the January effect have been about as accurate as tossing a coin.
When you think about it, it's pretty easy to understand why the indicator isn't reliable. Long-term investors know from experience that when you look to time the market over relatively short periods, it's almost impossible to have consistent success. Market moves can be almost random when you look at periods of a month or even a year. Over the long run, company fundamentals play the primary role in determining whether a stock rises or falls, but individual stocks can go for a long time without necessarily reflecting the fundamentals of their underlying business before reality finally sets in.
The better way to invest
Expecting the January effect isn't the smartest way to base your investing plan for 2019. Instead, the key is to focus on the long-term prospects of the companies in which you invest and regularly add money to the positions in which you have the most business confidence. That way you can ignore the discussions about the January effect and other attempts to time the market and find the better course toward long-term prosperity.
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