While investing often involves recognizing patterns in economic and market data, not all patterns are equally useful or valid. On the one hand, history shows that economic trends such as the business cycle and factors that drive corporate profitability, for instance, do impact markets. There are countless other patterns that investors follow that may or may not affect returns. Distinguishing between these types of patterns is important not only for portfolio outcomes but also to prevent counterproductive financial decisions. What do investors need to know about commonly discussed market patterns as they plan for the year ahead?
The January Effect has faded over time
One difference between the two types of patterns above is whether they explain market movements based on some underlying trend, or if they are simply surface-level observations.
The January Effect, is often discussed around this time of the year. This is based on the observation made in the mid-20th century that the month of January often experiences much stronger stock returns than other months. Some research even found that a large proportion of each year's return is generated during just a few days in January. Naturally, this implies that investors should dedicate their investment or trading activity to the month of January to take advantage of this effect.
Patterns such as these are referred to as market anomalies since standard theories for understanding stock returns can't easily explain why the January Effect should exist. Thus, it requires other explanations such as: tax loss harvesting in which investors sell stocks for tax purposes and buy them again in January, households investing holiday bonuses in January, portfolio managers selling stocks in December and buying again in January ("window dressing"), and many more. These explanations are often formulated after the fact, the reverse of the typical scientific process in which hypotheses are formulated first and then tested.
Investors should focus on long run trends instead
What does this mean for investors? Even when there is truth to surface-level patterns or seasonal effects, it's unclear what drives them or if they will continue. From a practical perspective, history suggests that it's better to focus on well-established drivers of markets which tend to operate over long time frames. The business cycle, corporate earnings, valuations, and other fundamental measures are not perfect predictors of market performance but they do tend to be correlated with returns over years and decades.
The bottom line? Investors should remain focused on long-run trends rather than seasonal market patterns as they work toward their financial goals.
