The Influence of Tax-Loss Selling by Individual Investors in Explaining the January Effect
Journal article by Ken Johnston, Don R. Cox; Quarterly Journal of Business and Economics, Vol. 35, 1996
Journal Article Excerpt
The influence of tax-loss selling by individual investors in explaining the January effect. by Ken Johnston , Don R. Cox INTRODUCTION Large abnormal returns for stocks in the month of January have been documented and examined by numerous researchers. These returns generally are shown to occur primarily for small firms and accrue mostly during the first five days of January.(1) Despite considerable attention, the cause of this phenomenon remains unresolved. This study provides a unique test of Ritter's (1988) tax-loss selling explanation of the January effect. Ritter proposes that abnormal returns in January are the result of the buying and selling behavior of individual investors who concentrate their investments in smaller firms. Near the end of each year individuals increase their selling of securities that have declined in value in order to realize tax losses. Reinvestment of funds early in the following year pushes up stock prices. Ritter's hypothesis assumes that individual and institutional investors concentrate in different stocks, that short-term buying and selling pressures affect stock prices, and that most individuals, seeing a direct tax benefit from selling of stocks that have incurred capital losses, have a stronger incentive to sell than many institutional investors who are largely unmotivated by such tax incentives. Consistent with his hypothesis, Ritter finds that there is a seasonal pattern in the turn-of-the-year buy/sell ratio of individual investors. Using a database of daily purchases and sales of New York Stock Exchange stocks by cash account customers of Merrill Lynch, he finds a below normal buy/sell ratio in late December and an above normal ratio in early January. Several additional studies examine other measures of trading activity around the turn of the year and show results that are generally consistent with Ritter. Keim (1989) documents a shift from trades at bid prices to trades at ask prices at the turn of the year. Such a pattern is consistent with individual investors being significant sellers in December and significant buyers in January. Dyl and Maberly (1992) examine odd-lot trading, as a measure of individual investor trading actions, and find that odd-lot sales are relatively higher in December than in January while odd-lot purchases are relatively higher at the beginning of the year than in December. Both of these changes are related significantly to January returns, but Dyl and Maberly are unable to conclude that the trading patterns are linked strongly to tax considerations. Badrinath and Lewellen (1991) analyze a large sample of actual common stock investment round trips undertaken by individual investor customers at a national brokerage house. They find a distinct seasonal pattern in this trading, with a concentration of loss-taking trades occurring late in the year. Badrinath and Lewellen, however, do not test for a link between this trading pattern and January returns. Taking a different approach from the above studies that concentrate on proxies of individual trading behavior, Eakins and Sewell (1993) examine Ritter's proposal that there is a link between January abnormal returns and institutional ownership. They find that institutions invest mainly in large firms and that the relation between January abnormal returns and the percentage of institutional holdings is negative. The lower the percentage of stock held by institutions, the higher the abnormal return in January. This implies a positive relationship between individual investors' ownership and the January abnormal returns. When Eakins and Sewell test the relationship within quintiles based on firm size, however, the parameter for the institutional ownership variable is significant only in the large firm quintiles (top two) and insignificant in the small finn quintiles (bottom three). They propose that this is due to most small firms having little or no institutional ownership. Thus, it is the evidence from the larger firms on which they are making inferences, even though the large firm groups should have a lower proportion of the worst performing stocks that are the most likely to be candidates for tax-loss selling. [See Chopra, Lakonishok, and Ritter (1992) for support of this point.] In this study, rather than examining a cross-section of all firms around the turn of the year, we specifically find and analyze those firms with large price declines that are targets for tax loss selling. In this way, we construct a more direct test of the link between tax-loss selling, individual ownership concentration: and abnormal returns in January. DESCRIPTION OF DATAThe initial sample of firms includes companies listed on the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) that have returns data available from the daily return tapes ... |
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