A perplexing phenomenon for money managers and academics alike is the so-called “January effect.”  Also known as the small-cap effect it generally refers to the fact that January tends to be a pretty good month for the stocks of smaller companies.  Despite efforts to come up with an explanation – window dressing by institutional investors, tax-loss selling and so forth – there seems to be no rational reason for the superior performance of these smaller company stocks early in every new year.  Before devling into my own radical theory, is this a real or mythical phenomenon?

Personally, I’ve bet on this phenomenon over many years – loading up the mutual funds I’ve managed with smaller companies during December that I considered inexpensive (their share prices were beaten up for any number of reasons).  The strong January investment performance would often put my portfolio in the top rankings for several months into the new year.  Always good for business.  I’d also encourage clients to buy our specialty fund that concentrated on smaller growth companies in early January, and hold it for a few months to capture the excess return.  It simply worked.

Experiencing or just believing in the effect is one thing, but does the data support the myth?  There are many studies confirming the anomaly.  I found the adjacent chart illustrating that in in January the smallest publicly traded companies indeed do better than the bigger companies.

“From 1926 through 2002, the smallest 10% of all stocks (or “10th decile”) beat the 1st decile stocks by an average of 9.35 percentage points in the month of January.”

Despite repeated efforts to explain why there is a January Effect, everyone agrees that it still remains pretty much a mystery.  Academics refer to such patterns as ‘anomalies.’  My own belief is that there are many instances when statistical observations are better explained by human behavior rather than analytics.

Ever notice that most babies are born in August and September?  Biologically speaking, this would suggest that our species do tend to act somewhat differently nine months prior to these births every year.  During the festive season there’s a whole lot of warm and fuzzy feelings that seem to influence our behavior.  In some cultures there’s a surge in indulgences – food and wine for instance – and for a brief couple of months stress and fear are reduced signficantly.  How do we respond?

Clearly we are inclined to be more intimate.  Couples (if you’ve been married for awhile you’ll understand this) successfully avoid romantic activity for most of the year; bored with their partners or simply turned off by their annoying habits and personality flaws.  Suddenly during the holidays we set aside our petty grievances and become more tolerant of one another. Those personality quirks might even seem endearing for a brief period.  Perhaps in the northern hemisphere humans are genetically engineered to seek warmth and companionship during the colder winter months?

Consider these cold hard facts:

• We are more than willing to be intimate (hence the birthrate 9 months later) despite the risks – being asked to do more chores around the house and such.
• During these months we spend recklessly on family and friends who don’t need the consumer items and in some cases don’t deserve them.
• People drink more alcohol than they should and eat food that is bad for them.

Why wouldn’t the perennial change in our emotional makeup also have an impact on our investment decisions?  My theory is that once a year risk-aversion takes a brief backseat in our psyche – and while our hearts and wallets are open why not take some free-spirited risk in the stock market?  Collectively hoping for a big score in those smaller company stocks that occasionally pay big, we all dive in together and cause their prices to rise.

The evidence of humanity’s willingness to take on more risk in the bedroom during the holidays becomes evident nine months later.  And it should come as no surprise that the financial consequences of investment decisions made in a fit of euphoria during the holiday season also show up by September of most every year also.  September is pretty much always the worst month for those stocks bought earlier in the year – small and large companies alike.

I certainly hope you had a good laugh reading my theory explaining the mysterious January effect.  In my opinion it is certainly as good as the explanations you’ll read in the media and academic journals.  Truth is there is much we’ll never understand about so-called ‘anomalies’ whether they occur in financial markets or in human behavior.  Simply knowing they do occur however can be a powerful tool when making one’s own investment decisions.  Come to think about it, just knowing about some behavioral anomalies might also help when it comes to family planning.

I wrote this article originally for the Website: www.money.ca.  I figure I should publish it here on my own site too so that these paradigm-shifting revelations are preserved.  (Yes, as the kids say, I am laughing-out-loud).