What Are Business Anomalies?
Anomalies:
In economics and finance, an anomaly is when the actual result under a given set of assumptions is different from the expected result predicted by a model. An anomaly provides evidence that a given assumption or model does not hold up in practice. The model can either be a relatively new or older model.
In finance, two common types of anomalies are market anomalies and pricing anomalies.
· Market anomalies are distortions in returns that contradict the efficient market hypothesis (EMH).
· Pricing anomalies are when something, for example a stock, is priced differently to how a model predicts it will be priced.
Understanding Anomalies
Anomaly is a term describing an event where actual results differ from results that are expected or forecasted based on models. Two common types of anomalies in finance are market anomalies and pricing anomalies. Common market anomalies include the small cap effect and the January effect. Anomalies often occur with respect to asset pricing models, in particular, the capital asset pricing model (CAPM). Although the CAPM was derived by using innovative assumptions and theories, it often does a poor job of predicting stock returns. The numerous market anomalies that were observed after the formation of the CAPM helped form the basis for those wishing to disprove the model.
Although the model may not hold up in empirical and practical tests, that is not to say that the model does not hold some utility.
Anomalies do tend to be few and far between. In fact, once anomalies become publicly known, they tend to quickly disappear as arbitragers seek out and eliminate any such opportunity from occurring again.
Examples of Market Anomalies
In financial markets, any opportunity to earn excess profits undermines the assumptions of market efficiency – which states that prices already reflect all relevant information and so cannot be arbitraged.
What are the Anomalies an investor should know before investment?
Seven Market Anomalies Investors Should Know
1. Small Firms Tend to Outperform
Smaller firms (that is, smaller capitalization) tend to outperform larger companies. As anomalies go, the small-firm effect makes sense. A company’s economic growth is ultimately the driving force behind its stock performance, and smaller companies have much longer runways for growth than larger companies.
A company like Microsoft (MSFT) might need to find an extra $6 billion in sales to grow 10%, while a smaller company might need only an extra $70 million in sales for the same growth rate. Accordingly, smaller firms typically are able to grow much faster than larger companies.
2. January Effect
The January effect is a rather well-known anomaly.
Here, the idea is that stocks that under performed in the fourth quarter of the prior year tend to outperform the markets in January. The reason for the January effect is so logical that it is almost hard to call it an anomaly. Investors will often look to jettison under performing stocks late in the year so that they can use their losses to offset capital gains taxes (or to take the small deduction that the IRS allows if there is a net capital loss for the year). Many people call this event “tax-loss harvesting.”
As selling pressure is sometimes independent of the company’s actual fundamentals or valuation, this “tax selling” can push these stocks to levels where they become attractive to buyers in January. Likewise, investors will often avoid buying under performing stocks in the fourth quarter and wait until January to avoid getting caught up in the tax-loss selling. As a result, there is excess selling pressure before January and excess buying pressure after January 1, leading to this effec
3. Low Book Value
Extensive academic research has shown that stocks with below-average price-to-book ratios tend to outperform the market. Numerous test portfolios have shown that buying a collection of stocks with low price/book ratios will deliver market-beating performance.
Although this anomaly makes sense to a point—unusually cheap stocks should attract buyers’ attention and revert to the mean—this is, unfortunately, a relatively weak anomaly. Though it is true that low price-to-book stocks outperform as a group, individual performance is idiosyncratic, and it takes very large portfolios of low price-to-book stocks to see the benefits.
4. Neglected Stocks
A close cousin of the “small-firm anomaly,” so-called neglected stocks are also thought to outperform the broad market averages. The neglected-firm effect occurs on stocks that are less liquid (lower trading volume) and tend to have minimal analyst support. The idea here is that as these companies are “discovered” by investors, the stocks will outperform.
Many investors monitor long-term purchasing indicators like P/E ratios and RSI. These tell them if a stock has been oversold, and if it might be time to consider loading up on shares.
Research suggests that this anomaly actually is not true—once the effects of the difference in market capitalization are removed, there is no real out performance. Consequently, companies that are neglected and small tend to outperform (because they are small), but larger neglected stocks do not appear to perform any better than would otherwise be expected. With that said, there is one slight benefit to this anomaly—through the performance appears to be correlated with size, neglected stocks do appear to have lower volatility.
5. Reversals
Some evidence suggests that stocks at either end of the performance spectrum, over periods of time (generally a year), do tend to reverse course in the following period—yesterday’s top performers become tomorrow’s under performers, and vice versa.
Not only does statistical evidence back this up, but the anomaly also makes sense according to investment fundamentals. If a stock is a top performer in the market, odds are that its performance has made it expensive; likewise, the reverse is true for under performers. It would seem like common sense, then, to expect that the over-priced stocks would under perform (bringing their valuation back in line) while the under priced stocks outperform.
Reversals also likely work in part because people expect them to work. If enough investors habitually sell last year’s winners and buy last year’s losers, that will help move the stocks in exactly the expected directions, making it something of a self-fulfilling anomaly.
6. The Days of the Week
Efficient market supporters hate the “Days of the Week” anomaly because it not only appears to be true, but it also makes no sense. Research has shown that stocks tend to move more on Fridays than Mondays and that there is a bias toward positive market performance on Fridays. It is not a huge discrepancy, but it is a persistent one.
On a fundamental level, there is no particular reason that this should be true. Some psychological factors could be at work. Perhaps an end-of-week optimism permeates the market as traders and investors look forward to the weekend. Alternatively, perhaps the weekend gives investors a chance to catch up on their reading, stew and fret about the market, and develop pessimism going into Monday.
7. Dogs of the Dow
The Dogs of the Dow are included as an example of the dangers of trading anomalies. The idea behind this theory was basically that investors could beat the market by selecting stocks in the Dow Jones Industrial Average that had certain value attributes.
Investors practiced different versions of the approach, but there were two common approaches. The first is to select the 10 highest-yielding Dow stocks. The second method is to go a step further and take the five stocks from that list with the lowest absolute stock price and hold them for a year.
It is unclear whether there was ever any basis in fact for this approach, as some have suggested that it was a product of data mining. Even if it had once worked, the effect would have been arbitraged away—for instance, by those picking a day or week ahead of the first of the year.
To some extent, this is simply a modified version of the reversal anomaly; the Dow stocks with the highest yields probably were relative under performers and would be expected to outperform.
What are the Common Behavioral Anomalies?
Common Behavioral Anomalies :
Nine Understanding Investor Behavior
1. Questioning Rationality Theory
Economic theory is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process. This assumption is the crux of the efficient market hypothesis.
But researchers questioning this assumption have uncovered evidence that rational behavior is not always as prevalent as we might believe. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision-making process. You’ll be surprised at what they have found.
2. The Facts About Investor Behavior
In 2001, Dalbar, a financial-services research firm, released a study entitled “Quantitative Analysis of Investor Behavior,” which concluded that average investors fail to achieve market-index returns. It found that in the 17-year period to December 2000, the S&P 500 returned an average of 16.29% per year, while the typical equity investor achieved only 5.32% for the same period—a startling 9% difference!
It also found that during the same period, the average fixed-income investor earned only a 6.08% return per year, while the long-term Government Bond Index reaped 11.83%.
In its 2015 version of the same publication, Dalbar again concluded that average investors fail to achieve market-index returns. It found that “the average equity mutual fund investor under performed the S&P 500 by a wide margin of 8.19%. The broader market return was more than double the average equity mutual fund investor’s return (13.69% vs. 5.50%).”
Average fixed income mutual funds investors also under performed—at 4.18% under the bond market.
Why does this happen? Here are some possible explanations.
3. Investor Regret Theory
Fear of regret, or simply regret theory, deals with the emotional reaction people experience after realizing they’ve made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock.
So, they avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. We all hate to be wrong, don’t we?
What investors should really ask themselves when contemplating selling a stock is: “What are the consequences of repeating the same purchase if this security were already liquidated and would I invest in it again?”
If the answer is “no,” it’s time to sell; otherwise, the result is regret of buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made—and a vicious cycle ensues where avoiding regret leads to more regret.
Regret theory can also hold true for investors when they discover that a stock they had only considered buying has increased in value. Some investors avoid the possibility of feeling this regret by following the conventional wisdom and buying only stocks that everyone else is buying, rationalizing their decision with “everyone else is doing it.”
Oddly enough, many people feel much less embarrassed about losing money on a popular stock that half the world owns than about losing money on an unknown or unpopular stock.
4. Mental Accounting Behaviors
Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves.
Say, for example, you aim to catch a show at the local theater and tickets are $20 each. When you get there, you realize you’ve lost a $20 bill. Do you buy a $20 ticket for the show anyway?
Behavior finance has found that roughly 88% of people in this situation would do so. Now, let’s say you paid for the $20 ticket in advance. When you arrive at the door, you realize your ticket is at home. Would you pay $20 to purchase another?
Only 40% of respondents would buy another. Notice, however, that in both scenarios, you’re out $40: different scenarios, the same amount of money, different mental compartments. Pretty silly, huh?
An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy, albeit paper, gains. When the market correction deflates investor’s net worth, they’re more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that profitable period.
5. Prospect- and Loss-Aversion
It doesn’t take a neurosurgeon to know that people prefer a sure investment return to an uncertain one—we want to get paid for taking on any extra risk. That’s pretty reasonable.
Here’s the strange part. Prospect theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more stressed by prospective losses than they are happy from equal gains.
An investment advisor won’t necessarily get flooded with calls from her client when she’s reported, say, a $500,000 gain in the client’s portfolio. But, you can bet that phone will ring when it posts a $500,000 loss! A loss always appears larger than a gain of equal size—when it goes deep into our pockets, the value of money changes.
Prospect theory also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what’s already been lost.
So, despite our rational desire to get a return for the risks we take, we tend to value something we own higher than the price we’d normally be prepared to pay for it.
The loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners: they may believe that today’s losers may soon outperform today’s winners. Investors often make the mistake of chasing market action by investing in stocks or funds which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than money flows out from funds that are under performing.
6. Investor Anchoring Behaviors
In the absence of better or new information, investors often assume that the market price is the correct price. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities.
In bull markets, investment decisions are often influenced by price anchors, which are prices deemed significant because of their closeness to recent prices. This makes the more distant returns of the past irrelevant in investors’ decisions.
7. Over- and Under-Reacting
Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring, or placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events, which results in prices falling too much on bad news and rising too much on good news.
At the peak of optimism, investor greed moves stocks beyond their intrinsic values. When did it become a rational decision to invest in stock with zero earnings and thus an infinite price-to-earnings (P/E) ratio (think dotcom era, circa the year 2000)?
Extreme cases of over- or under-reaction to market events may lead to market panics and crashes.
8. Investor Overconfidence
People generally rate themselves as being above average in their abilities. They also overestimate the precision of their knowledge and their knowledge relative to others.
Many investors believe they can consistently time the market, but in reality, there’s an overwhelming amount of evidence that proves otherwise. Overconfidence results in excess trades, with trading costs denting profits.
Is Irrational Behavior an Anomaly?
As we mentioned earlier, behavioral finance theories directly conflict with traditional finance academics. Each camp attempts to explain the behavior of investors and the implications of that behavior. So, who’s right?
The theory that most overtly opposes behavioral finance is the efficient market hypothesis (EMH), associated with Eugene Fama (University of Chicago) & Ken French (MIT). Their theory that market prices efficiently incorporate all available information depends on the premise that investors are rational.
EMH proponents argue that events like those dealt with in behavioral finance are just short-term anomalies or chance results and that over the long term, these anomalies disappear with a return to market efficiency.
Thus, there may not be enough evidence to suggest that market efficiency should be abandoned since empirical evidence shows that markets tend to correct themselves over the long term. In his book Against the Gods: The Remarkable Story of Risk (1996), Peter Bernstein makes a good point about what’s at stake in the debate:
While it is important to understand that the market doesn’t work the way classical models think—there is a lot of evidence of herding, the behavioral finance concept of investors irrationally following the same course of action—but I don’t know what you can do with that information to manage money. I remain unconvinced anyone is consistently making money out of it.
9. Sticking with Solid Strategies
Behavioral finance certainly reflects some of the attitudes embedded in the investment system. Behaviorists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities—not to mention opportunities to make money.
That may be true for an instant, but consistently uncovering these inefficiencies is a challenge. Questions remain over whether these behavioral finance theories can be used to manage your money effectively and economically.
That said, investors can be their own worst enemies. Trying to out-guess the market doesn’t pay off over the long term. In fact, it often results in quirky, irrational behavior, not to mention a dent in your wealth.
Implementing a strategy that is well thought out and sticking to it may help you avoid many of these common investing mistakes.