What Drives the Market
The market is easily affected by various factors and forms ups and downs. There are usually two factors that may come to the fore in year-end market volatility.
Window dressing
Window dressing is a technique employed by managers of mutual funds to make them look good before presenting them to clients or shareholders. Mutual fund managers will dispose of underperforming stocks and purchase well-performed ones in order to give the impression that they are on top of the market to investors who look at the portfolio at the end of the quarter or year.
Tax-loss selling
Tax-loss selling, also known as tax-loss harvesting, is a strategy that involves selling assets with capital losses in order to reduce or eliminate the capital gain realized by other investments for income tax purposes. Due to the fact that capital losses are tax-deductible, they can be used to offset capital gains and lower an investor's overall tax burden. In order to realize capital losses for the upcoming income tax season, investors frequently engage in tax selling in November and December, adding to the selling pressure on some stocks. Once the new year begins, the proceeds from those sales are often redeployed back into the market, sending some oversold stocks rebounding.
Example
Assume, for illustration, that an investor sold A stock for a gain of $30,000 in capital. Since they are in the highest tax bracket, they must pay the government $6,000 in capital gains tax, or 20% of their income.
But suppose they lose $10,000 on the sale of the B stock. They will only be required to pay $20,000 in capital gains tax because their net capital gain for tax purposes will be calculated as follows: $30,000 - $10,000 = $20,000. Observe how the gain on A is offset by the realized loss on B, which lowers the investor's tax bill. However, the tax loss selling strategy can defer tax payments but does not cancel them.
What should average investors do?
Average investors should be cautious about insider trading activity that takes place in (late) December.
If there is window dressing, demand for those stock "winners" of the past year will increase.
If there is tax-loss selling, the prices of some poorly-performing stocks will decrease further when many sellers realize the losses at once. However, shares that have become incredibly oversold have a chance to recover in January next year.
Therefore, buying lows and selling highs would be an alternative for investors who prefer profiting from such kinds of short-term volatility.