Why do stocks go down at the end of the year?

The end of the year is often linked with a downturn in the stock market. But why exactly do stocks go down at the end of the year? We take a look.

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The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

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If you are an investor or if you follow stock market news regularly, you might have heard the theory that the stock market takes a dip at the end of the year. But why would stocks go down at the end of the year? Can investors profit from this situation? Let’s take a closer look.

[top_pitch]

Why do stocks drop at the end of the year?

Analysts generally attribute the fall in stock prices at the end of the year to tax-loss harvesting. This is where investors evaluate their portfolios and sell stocks that have underperformed in value throughout the year. They do this so that they can claim capital losses against their tax bill.

This is especially true in countries where the tax year ends at the end of the calendar year. An example is the US, where the tax year starts on 1 January and ends on 31 December.

The ultimate effect of a stock sell-off at the end of the year is a drop in stock prices.

What about the start of the new year?

The drop in prices at the end of the year is almost always followed by a rise in prices at the start of the new year. This is known as the ‘January effect’.

According to some experts, the January effect is the result of investors who may have sold off their underperforming stocks at the end of the year returning to the market to repurchase them. They rebuy them in order to hold them for another year of potential gains. This demand from those who have sold off, as well as bargain hunters, tends to drive up stock prices.

Another alternative theory for the rise in demand in January is the effect of year-end bonuses that individuals receive from their workplaces, which are then invested in the stock market.

Some also believe that the January effect has something to do with consumer sentiment. Because January marks the start of a new year, some investors may believe that it’s the best time to begin their investing journey.

[middle_pitch]

Can you profit from the end-of-year drop in prices?

First of all, the seasonal anomaly of stock prices dropping at the end of the year and then rising in January is currently hotly debated. For example, although the ‘January effect’ theory enjoyed some acceptance in the past, some argue that modern markets are too efficient to be influenced by such a phenomenon.

Furthermore, more people invest using tax-sheltered investment vehicles such as stocks and shares ISAs here in the UK. Consequently, they have less reason to sell at the end of the year in order to claim capital losses.

Still, the phenomenon is real enough to have some serious research and news coverage behind it. So that really makes you think.

Should you try to time the market?

Although it sounds good in theory, many experts will tell you that trying to time the market simply doesn’t work. The proven way to profit from the stock market is to buy good, solid stocks and hold them for the long term

Swings in the stock market in the course of the calendar year are relatively common. Over the long term, however, the market has an upward bias. You’ll almost always make gains if you’re patient. Of course, past performance is not a predictor of future results.

If you’re looking to get more value for your cash when buying stocks, a much better bet, rather than trying to buy at the ‘right time’ is to use the pound-cost averaging strategy. This is where you invest a specific sum of money at predetermined intervals over time.

By purchasing stocks at various prices on a regular basis, you increase your chances of paying a lower average price for these stocks than you would if you attempted to purchase them at a time that you believe is just right.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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