Laura Rowley Money & Happiness

Apparently, compensation plans can do odd things to the stock market.

Consider the January Effect, a market trend in which small-cap stocks start to rise in value at the end of December and continue through early January. It's typically thought to occur because of year-end selling to create tax losses or recognize capital gains; or because of so-called "window dressing" by portfolio managers.

The Effect Explained

The effect has been recognized for two decades, and typically such a phenomenon disappears when it becomes widely acknowledged and exploited by investors. But this year-end trading opportunity continues to persist in part, according to researchers, because of the way fund managers are paid.

"Most managers' compensation packages depend on beating the S&P 500 or some other large-cap index," says Mark Hulbert, founder of the Hulbert Financial Digest. "If you're in October, and you're well ahead of the S&P 500, you know if you can hold on you'll get a nice year-end bonus. It's incentive to make the portfolio look progressively more like the S&P as the year goes on, to preserve the margin by which you're ahead."

Thus, even if the S&P 500 declines, it won't affect the manager's compensation.

"Their greatest incentive to invest in small caps is in January, and the lowest is in December -- and there's evidence that suggests managers behave that way," says Hulbert.

Taxes Play a Part

One of the traditional theories was that the January Effect was mainly caused by year-end tax selling. "There's no doubt tax-loss selling plays a part," says Hulbert, who adds that new research suggests the phenomenon has been around since the 1940s.

"However," Hulbert continues, "there are countries around the world which do not have a capital gains tax, so tax-loss selling is not going to play a part in those countries' stock markets. And they, too, seem to have the January Effect."

While there's no guarantee, investors who capitalized on the strategy between Dec. 20 and Jan. 9 profited in 22 of the last 24 years. (They took a beating at the end of 1998 and 2004.)

Playing the Effect

What's the best way for individual investors to play the trend today? Hulbert suggests a method that's been around since 1989: Buy a futures contract today, Dec. 20, on the Value Line Arithmetic Index, and sell short a futures contract of an equal dollar amount on the S&P 500. Exit both positions on Jan. 9.

This approach works if small caps outperform large caps because the Value Line Index holds more small-cap stocks than the S&P 500. With this tactic, "you're not making a bet on the market but on relative performance -- and it has the least amount of commission," Hulbert notes.

For investors who aren't comfortable trading futures, another approach is to purchase an exchange traded fund (ETF) focusing on small caps, such as the iShares Russell 2000 Index (IWM), and short the iShares Trust S&P 500 Index (IVV) by an equal dollar amount, exiting both positions by Jan. 9, Hulbert says. (Don't try to exploit the trend using mutual funds, because most charge additional fees to discourage short-term trading.)

Year-End Tax Moves

The year's end also brings a last-minute opportunity for tax savings. Here are a few quick tips to reduce your 2007 tax liability:

• Harvest tax losses.

Selling an investment that's fallen in value to offset capital gains elsewhere seems like a no-brainer, but most investors don't do it, according to a study released last year by Fidelity Research Institute, an arm of the mutual fund giant.

Looking at 185,000 households served by Fidelity Brokerage in 2003, the study found 67 percent didn't take full advantage of their unrealized losses. Only 10 percent took advantage of the full $3,000 ordinary deduction allowed under the tax code. Most of the households could've gained $500 in tax savings.

Here's an example: An investor purchases a stock for a total of $30,000. It is currently worth $27,000. The investor sells the position and secures tax savings on this year's tax return. If this household had an adjustable gross income of $100,000, harvesting a $3,000 loss would have lowered their tax bill by $450 if the position was held long-term (more than a year) and $750 if it was held short-term.

• Defer income and accelerate expenses.

If you expect a bonus or large commission, find out if the payment can be deferred until January. Self-employed professionals can reduce taxable income by billing clients for current work at the very end of the year. Meanwhile, buy that new laptop, office furniture, or other equipment and supplies before Dec. 31 on your credit card so you can take the deduction for the business expense this year and pay the bill in 2008.

You can save on taxes by pre-paying your first quarter 2008 property taxes, January mortgage, or state and local income taxes -- but watch out for the alternative minimum tax, says Elda Di Re, a partner with Ernst & Young. "When you're talking about accelerating deductions, you need to be sure you understand what your AMT situation is," she says. "Once you're into the AMT, additional deductions in those areas are of no benefit to you."

Use tax software to calculate your income, deductions year-to-date, and your current estimated tax, and then see what happens when you increase deductions or charitable contributions, Di Re suggests.

• Boost charitable donations.

Ideally, you should donate appreciated securities. You'll get the deduction for the fair market value on the date of the transfer, pay no capital gains taxes, and the charity can sell it tax-free. One caveat: It has to be stock you've held for at least a year.

Seniors over age 70-1/2 can make a donation of up to $100,000 directly from their Individual Retirement Accounts (IRA) to a charity -- but that benefit expires this year. "It's a nice way of avoiding income tax on your distribution," says Di Re, adding that donors may still have to pay state income tax on the contribution in states that don't have itemized deductions.

• Max out retirement savings.

Depending on your plan administrator, you may still be able to increase your 401(k) contribution if you're paid weekly and haven't maxed out contributions. As long as the plan deferral election is made before the participant earns the money, there are no IRS limitations about how much you can defer in a single pay period.

For example, some larger 401(k) plans allow you to contribute 100 percent of your last paycheck to the plan, according to a spokesperson with financial services firm TIAA-CREF. Check with your plan administrator. In 2007, the maximum 401(k) contribution is $15,500 ($20,500 for those over age 50).

• Open a college savings fund.

A number of states provide a tax deduction for contributions to their 529 plans. For example, New York provides a deduction of up to $10,000 if you're married and filing jointly.

"If you are in the highest tax bracket, you would save $700 if you're a state resident, and more than $1,000 if you're a New York City resident," says Di Re. To see if your state plan offers a deduction, visit the College Savings Plans Network.

Working Ahead

Garnering last-minute tax savings not only keeps more green in your pocket, it makes April a lot less painful. "If you figure out your charitable contributions and real estate taxes, you've done half the work toward your tax return," says Di Re.

For more last-minute tax-savings ideas, see my blog.