Why you can't cash in on the "January effect"

Author: Jason writer

Every year, the drumbeat among market pundits starts in late fall, reaching a crescendo around Martin Luther King Jr. Day: You can make a killing by buying small stocks low in December and selling them high in January. History "proves" that the January effect will beat the market.

I'm not saying that the January effect isn't real; it is. If you had bought an equal dollar amount of the smallest 10 percent of U.S. stocks on the last day of December every year since 1926, then sold on the last day of January, you would have earned an average return of 11.3 percent. That's as much in a month as the entire stock market does in a typical year.

But while the January effect is real, cashing in on it is an illusion - a classic case of how Wall Street uses real data to promote financial fantasy.

Most investors have heard of small-cap stocks, or companies whose shares have a total market value of under $2 billion or so. You may also have heard of microcaps, whose market value is $500 million or less.

But it's not those stocks, which you or your mutual fund might own, that drive the January effect.

Tim Loughran, a finance professor at the University of Notre Dame who has crunched the numbers, has found that much of the January effect has come from stocks so tiny - with market values under $100 million - that very few mutual funds (and hardly anyone else) owned them.

In 1992, for example, the smallest stocks soared 24.3 percent in January while large ones dropped 1.6 percent. But much of the bang came from a handful of these nanocaps. For a grand total of 27 cents, you could have bought one first-class stamp - or one share apiece in five of the hottest of these stocks.

On Dec. 31, 1991, some lucky soul bought $1,093 worth of a shrimpy software stock called OCG Technology, which closed for less than 5 cents a share. OCG then went up 2,400 percent in January.

That was enough to ratchet up the reported January effect for years all by itself. (Yes, 1992 was a while ago, but these results are typical.)

Loughran points out another logical flaw in the January effect: Everyone assumes you can trade these tiny stocks at zero cost. Last I checked, not many brokerage firms were run as charities.

Commissions, "spreads" (the gap between buying and selling prices) and a technicality called the "bid-ask bounce" add up so fast that it costs big bucks to trade small stocks.

Loughran found that if you paid an absurdly low 12.5 cents a share, the average annual return of the January effect would drop by 8.9 percentage points.

In other words, small stocks earn higher returns in January if you're an imaginary investor who trades for free. In the real world, you can't do it.

So what should you do in January? Instead of juggling small stocks in hopes of capturing a fantasy profit, get real. Review your year-end account statements. See whether any of your holdings charged excessive fees, triggered high tax bills or prompted you to trade more than a few times last year. Then resolve to clean up your portfolio in the new year. Unlike the "real" January effect, this will give you a boost that's no illusion.