The small-firm-in-january effect

Introduction
In the early fifties economist Maurice Kendall1 found to his great surprise that he could not
find predictable patterns in stock values. At any moment stock prices where just as likely to
go up as they were to go down. This irrational pattern in stock values does not indicate an
irrational market at all, in contrary, it indicates an efficient market where prices are set in such
a way they reflect the correct value of the stock so no arbitrage oppurtunities exist. This
means that all information is already reflected in the price level, so the only reason of
fluctuation in stock value would be the arrival of new information. Predicatablility of stock
value in contrary would indicate that not all information is incorporated in the price and thus
market inefficiency. The notion that all information available is already incorporated in the
stock price is referred to as the ‘Efficient Market Hypothesis’. Although this notion is
generally excepted still patterns of returns can be observed which can not be explained with
this hypothesis, Findings such as this are called anomalies. In this paper one of these
anomalies, discovered by Rolf Banz2, the so called small-firm-in-january effect, will be
examined in order to get a better understanding of this theory and its possible shortcomings.

Problem question: Does the small-firm-in-january effect indicate an inefficient market?

Analysis

I will start my analysis of this problem by explaining what exactly is the small-firm-in-
january effect, afterwards several possible explanations of this effect will be introduced and
finally we will take a look at the open spaces left.

What exactly is the small-firm-in-january effect

Historical performance shows that the 10% smallest funds traded on stock exchanges
consistently ouperformed the largest 10%, even after this differences are adjusted using the
CAPM (Capital Asset Pricing Model) concerning the characeristic of smaller firms of being
riskier. Another historical effect that can be observed is that the January stock returns exceed
those in all the other months significantly.
 Hypothesises explaining the small-firm-in-january effect

An hypotheses which explaines this deviation is that the increase in January is a rebound to
the tax-loss sales undertaken in the month december. Stocks that decreased during the year
often are used to decrease income by realizing this capital loss so less taxes will be payed. Jay
R. Ritter (1988)3 proved that stock purchases at the end of december are at an annual low and
in January are at an annual high. Even more precize, the entire January effect is created in the
first two weeks of the month.
This should be explained by the theory that the investors participating in the tax-loss selling at
the end of december enter the market again in early January. Due to this demand is higher and
so stock prices increase. A possible reason why this January effect is strongest for the smallest
firms can be explained by their higher votality, this leads to deeper decreases in price which in
their turn will lead to a higher salesvolume in december and higher purchase volume in early
Jaunary.

Another not directly observable or explainable reason why smaller firms have a better average
performance than larger firms might be caused by the fact that larger, better known
companies are better monitored and so better information, quantitative as well qualitative, is
available. Smaller more neglected firms tend to be perceived riskier due to this information
deficiency. Merton (1987)4 argued that the premium for this more neglected firms does not
indicate market ineffiecieny, but is rather a more hidden type of risk premium.
Furthermore smaller firms tend to be more illiquid than larger firms which creates an
illiquidity premium upon total return.

Deficiencies of the current hypothesises

As far as the January effect would be created by an increased buying pressure, a similar
symmetric effect sould be observed in december due to an increased sales pressure. The
absence of this makes you question the sales-loss undertaken in december theory as being a
satisfying explanation. Also the theory explaining the point of the’abnormal’ high returns for
smaller sized companies does not indicate any reason at all about why these high returns are
completely created in the month January. Obviously there is not jet found a totally satisfying
explanation of the anomalie. Perhaps the solution for the problem can be found in the area of
psychological finance. Perhaps investers tend to be more willing to participate in risky
investments in the beginning of the year due to the collectment of the’thirteend month’ and
other extra’s collected by individual investors as well as investment companies. It is proved
that the loss of for example 50 euro is perceived as less worse when eiter the money is part of
a bigger amount or if the money is acquired without a direct service in return(thirteend
month).

Conclusion

Although so far there isn’t a satisfying explanation found for the small-firm-in-january effect
there also isn’t any real proof that should reject the efficient market hypothesis. Like with a
lot of other anomalies it is not unthinkable that in the future a good explanation for this
phenomenon will be found.

References
1
Maurice Kendall, “the analysis of economic time series, part I: prices, “Journal of the royal statistical society 96 (1953)
2
Rolf Banz, “The relationship between return and market value of common stocks,” Journal of financial economics 9
(March 1981)
3
Jay R. Ritter, “The buying and selling behavior if individual investors at the turn of the year,” Journal of Finance 43 (July
1988)
4
Robert C. Merton, “A simple model of capital market equilibrium with incomplete inforrmation,” Journal of Finance 42
(1987).