Saturday, December 18, 2004

Tax year trading and wash sales--Grinblatt and Keloharju

With the end of the year rapidly approaching it is a good time to consider taking any tax losses that you can to lower this year's tax bite. And guess what? You will not be the only one doing this!

Grinblatt and Keloharju provide us an interesting look at tax year trading in the Finish Stock Market in their upcoming JFE article.

After showing that many researchers have hypothesized the existence of a large number of wash sales (example Ritter 1988), the selling of losers in December and then buying them back had not been empirically documented.

Finland, lacking all wash sales restrictions and with a remarkable electronic database on the trades of all domestic
investors, provides an ideal environment for analyzing the relation between the turn of the year and wash sales.

And sure enough, the authors find that investors do sell shares, recognize the loss, then are more likely to again buy shares in the same firm.

In the authors words:

First, we analyze, on a daily basis, the proportion of stocks with gains that are realized and the proportion of stocks with losses that are realized in the 50 trading days around January 1 of the years 1996-2000. We show that the ratio of these two proportions, aggregated over all Finnish households,
decreases markedly in the last eight trading days of December and then exhibits an abrupt increase commencing on the first trading day of January.

We also show that the rate of repurchase is highly linked
to the turn of the year and the size of the capital loss. This supports Ritter's hypothesis that repurchases are tied to tax-motivated sales....

To explore the role of firm size in this trading pattern, we show that the timing of repurchase activity as a fraction of volume in small stocks has much more of a turn-of-the-year seasonal than the timing of repurchase activity for large stocks.

Isn't it cool when something we thought was there really is! And to make things even better they also found more evidence that supports the Keim's (1983 and 1989) explanation of why small firms outperform large firms in January.

The paper concludes with the requisite discussion of the extent to which these findings can be generalized to other countries. Their conclusion, to which I agree, is that while tax laws are different (for instance in the US you can not immediately buy back the same stock, but rather have to resort to buying back a close substitute if your intent is to lower taxes), the idea likely does hold.

From the JFE--remember this will be moved once the paper goes to press:

From SSRN: (this is an older working copy version of the paper)

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