Stocks’ yearly performance rankings are a field day for contrarians: One year’s worst often are the subsequent year’s best, and vice versa.
Stunning as this reversal is, it is not unique. Investors should take the contrarian lesson to heart and consider buying stocks at the bottom of the performance rankings. The main cause of these year-to-year reversals is investor sentiment, with supporting roles played by tax-loss selling and end-of-year window dressing. Sentiment is the big culprit because investors’ moods swing between extremes. When they are optimistic about a stock, they tend to become way too excited; just the opposite is the case when a stock falls out of favor. In true contrarian fashion, the in-favor stocks tend to fall out of favor, and vice versa.
Tax-loss selling occurs when investors sell stocks at a loss in order to offset some of the capital gains on which they would have to pay tax. End-of-year window dressing occurs when portfolio managers sell losers in order to avoid the embarrassment of having to list them in end-of-year reports. In both cases, stocks that are already down as the end of the year approaches are punished even more. It makes sense that they would bounce back in the new year.
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