“At the beginning of the year, people want to make a fresh start,” says Stephen Ciccone, a professor at the University of New Hampshire’s Whittemore School of Business and Economics. “They resolve to quit smoking or lose weight and many fail by February. Another way people try to improve themselves is related to finance; people are more optimistic in January.”

This optimism is infused into stock markets. “All stocks do better in January,” he says. “And smaller stocks outperform large ones—the same small stocks that actually underperform in the other 11 months of the year.”

So, what does the January effect mean for investors and how can advisors make it work to clients’ advantage?

Why January?

There are two traditional explanations. The first is tax-loss selling: people sell small, low-performing stocks every December to realize capital losses and then buy them back in January. The second is window dressing: institutional investors bleed themselves of low-performing—often smaller stocks—before they report their holdings on December 31, and then buy them back in January.

Optimism that occurs in January may also be a key driver. This euphoria in the market then influences prices at the beginning of the year.

What the research says

Ciccone’s research looked at earnings forecasts between January 1983 and December 2007, and identified stocks that are the most susceptible to investor optimism every January: those with high forecast dispersion.

“Much depends on analysts’ predictions. The stocks with the most disagreement in their earnings forecasts tended to do better in January than those associated with more uniform forecasts,” he says. “Smaller stocks outperformed larger stocks. And small stocks with high dispersion outperformed all other stocks in January.”

Further, small stocks with high dispersion realized monthly gains of 4.5% in the first month of the year, compared to 0.81% on average for big, low-dispersion stocks.

How to help clients

If a client’s in the right stocks, it’s possible to take advantage of this effect. “Help them ride the wave of optimism, at least for the month. They can buy the small stocks with high dispersion as others are dumping them in December and sell them in early February,” says Ciccone. “In my sample period, these same stocks earn just 0.08% monthly for the rest of the year, compared to 1.22% for bigger, lower-dispersed stocks.”

Advisors beware

This effect is well documented, so you’d think people would discontinue this buy-lose-sell pattern. But the research suggests otherwise. Investors optimistically buy small stocks every January, watch them underperform the rest of the year, and then do it all over again the next year.

“Advisors can keep an eye on trading patterns—there may be some value in buying and selling for tax advantages in December and January,” Ciccone notes. “But clients may want to shift their stocks and make different decisions the following 11 months.”

Brynna Leslie is an Ottawa-based financial writer.