Errors in Recorded Security Prices and the Turn-of-the-Year Effect

Abstract

Errors in recorded security prices are a source of misspecification in the market model. If recorded price errors are sufficiently nonrandom, they result in biased returns and in biased and inconsistent estimates of market model regression coefficients. This paper argues that tax-induced flow-supply pressures cause end-of-the-year recorded price errors to be nonrandom enough to create the appearance of anomalous turn-of-the-year stock return behavior. Empirical tests of returns and market model regression coefficients during the turn-of-the-year period cannot reject this errors-in-variables explanation of the turn-ofthe-year effect. The turn-of-the-year (TOY) effect (or January effect) refers to the anomal? ous behavior of stock returns during the last five trading days in December and the first five trading days in January. This anomaly is of particular interest to financial researchers because it appears to be a small-firm effect and the source of the majority of size-related anomalies (see Keim (1985), Reinganum (1981), and Roll (1983a), 1983b)). The interest in the TOY effect is justified because of its implications concerning the validity of the Capital Asset Pricing Model (CAPM) and market efficiency. In this paper, we show that there is a price-related effect operating during the TOY period. First, we show that the magnitude of the TOY return is inversely related to price. When we control for price, most of the size-related TOY effect found by Reinganum (1983) and Roll (1983a) disappears. Second, the data indicate that all firms have unusually high returns during the TOY period compared with their returns during the rest of the year. Third, we find seasonal shifts in the market model betas associated with the TOY period. Furthermore, we test the hypothesis that the TOY effect is an errors-in-variables problem due to the use of the one-eighth pricing convention in recording security prices and the accommodation of tax-induced flow pressures by liquidity traders (such as market