Avoid a Big January Tax Bill Without Sacrificing Performance

For decades, researchers have observed abnormally high returns for small capitalization stocks in the month of January, an anomaly now called the “January effect.” One study suggests that half of the small cap premium (the excess return of small cap stocks over large cap stocks) is reaped in January alone and most of the outsized performance occurs in the first week of trading, particularly on the first day. It’s not exactly clear what drives the January effect, although there are several theories.

One explanation is year-end “window dressing” by fund managers. Other theories include investors putting year-end bonuses to work, or getting back into the market after December tax-motivated selling.

Yet whatever the rationale, the January effect has some important consequences for tax management.

For many investors and financial advisors, December is the big month for tax-loss harvesting. Under wash-sales rules, if the loss is booked in the current tax year, a “substantially identical” security cannot be repurchased for 30 days.

Importantly, if a stock is sold in December, it can’t be bought back until January. That leaves two choices: Sit in cash and wait out the wash-sale period, or purchase a comparable stock to hold as a substitute in the meantime.

Both choices have risks. In the first (staying in cash), there is a risk of missing any rally in January. The second choice may lead to difficult decisions later. For example, if stocks rally, the less-optimal substitute security is now at a short-term gain, which could make it costly from a tax perspective to transition back into the preferred holding.