MARKET ANOMALIES

A market anomaly is a price action that contradicts the expected behavior of the stock market.
Traders and investors can use these unusual market behaviors to find opportunities throughout
the stock market.

A market anomaly refers to the difference in a stock’s performance from its assumed price
trajectory, as set out by the efficient market hypothesis (EMH). EMH assumes that share prices
reflect all of the information available at any given time. In theory, this should make it
impossible to purchase overvalued stocks, or sell a stock above its value, because it would
always trade at a fair market price.

But, in practice, efficient markets are difficult to create and even more difficult to maintain. The
appearance of financial market anomalies provides evidence that the EMH doesn’t always hold
true, as not all relevant information is priced in straight away or at all.

1. Calendar effects

Calendar effects are a group of anomalies that occur at particular times or on particular dates
throughout the year. They are:

a) Monday effect

The Monday effect, also known as the ‘weekend effect’, is the tendency of stock prices to close
lower on Mondays than on the previous Friday.

Many supporters of behavioral finance speculate that the Monday effect is caused by negativity
surrounding a new working week. But others believe that a more likely explanation of the
weekend effect is that companies often release bad news on Friday evenings, after the market has
closed. This would be supported by the tendency of investors to sell off their stocks on Friday
afternoons to avoid slippage over the weekend.

b) Turn-of-the-month

Turn-of-the-month refers to the pattern of a stock’s value rising on the last day of each trading
month, with the price momentum continuing for the first three days of the next month.

Historically, the out-sized gains at the turn of each month have a higher combined return than all
30 days in the month. There is little agreement about whether this is just a coincidence of random
behavior, or the result of positive business news being more likely to be announced at the
end of the month.

c) January effect

The January effect is a rather well-known anomaly. According to the January effect, stocks that
underperformed 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.
The January effect describes the pattern of increased trading volume, and subsequently higher
share prices, in the last week of December and the first few weeks of January.

While it is also known as the turn-of-the-year effect, the term ‘January anomaly’ is more
commonly used to refer to the tendency of small-company stocks to outperform the market
in the first two to three weeks of January.

It is believed that the January effect is caused by the turn of the tax calendar. Typically,
according to this theory, prices drop in December when investors sell off their assets in order to
realize capital gains. And the increases in January are caused by traders rushing back into the
market.

2. Holiday effect

The holiday effect, or per-holiday effect, is a calendar anomaly that describes the tendency for
the stock market to gain on the final trading day before a public holiday.

The most frequently cited explanation for this is that people are naturally more optimistic
around holidays, which can translate into positive market movement. An alternative
explanation is that short-sellers are more likely to close their positions prior to holidays.

The holiday anomaly can also be attributed to expectations that there will be volatility at
these times – the holiday effect becomes self-fulfilling, as traders buy or sell around the same
historical anomalies.

3. Post-earnings-announcement drift

The post-earnings-announcement drift is the name given to the pattern of stock returns
continuing to move in the direction of surprise earnings. This anomaly follows a company
announcement and is caused by the market gradually adjusting to new information.

In theory, if markets were entirely efficient, then company earnings announcements would cause
an immediate shift in prices as the report is instantly factored into the market price. However, in
practice, it can take up to approximately 60 days for markets to adjust – with a positive earnings
announcement causing an upward drift, and a negative earnings announcement causing a
negative earnings drift.

The most widely accepted reason for this delay is that markets under-react to earnings reports,
and so it takes a period of time before the information gets absorbed into the stock’s price.

Post Earning Announcement Drift

´Post-earnings-announcement drift describes the tendency of stock prices to
continue to behave as if investors were still anticipating corporate results, good or bad,
despite the fact that the results have been published and are widely known.

Ahead of an earnings announcement, such as full-year profit figures, stock prices often

move in anticipation of the expected outcome - generally upwards, in the case of likely

good figures, and generally downwards, when the outlook is thought to be poor. The

publication of the figures may be expected to end this trading pattern because

the facts are now known and should be incorporated in the price.

However, there is an observable tendency for the share price to continue to move

in the direction in which it had travelled ahead of the figures, almost as if the

results have yet to be announced. This can continue for about two months after the

announcement.

4. Momentum effect

The momentum effect is based on historical technical analysis that suggests recent stock
market ‘winners’ are more likely to continue to outperform the ‘losers’ – or that stocks
with a strong upward trajectory are likely to continue to rise in the short to medium-term.

The momentum anomaly suggests that traders can take advantage of these price movements by
going long on winners and shorting the losers.

One of the popular explanations for the momentum effect is that markets do not immediately
price in new information but do so more gradually.

Let’s say a company releases good news, but buyers under-react and take a while to flood the
market, the price increase would be more gradual. This makes it appear that the winners are
taking consistent gains.

5. Value effect

Perhaps one of the most well-known fundamental anomalies is the value effect. This anomaly
refers to the tendency of stocks with below-average balance sheets to outperform growth
stocks on the market, due to investor belief in companies’ potential.
Normally, if the market value is higher than the book value per share, a stock is considered
overvalued, while a stock with higher book value than market value is often thought of as
undervalued. While this would usually prompt the market to correct, the value effect sees traders
behaving counter to accepted practice and buying shares that are technically overvalued.

Although there is increased risk in investing in low-book-value stocks – as they could fall
into financial distress – it is weighed up against the potential for superior returns.

The "Anomalies" that behavioural finance seeks to explain:

1. January Effect
Average monthly return for small firms is consistently higher in January than any other month of
the year. 

Conversely, EMH suggests a "random walk"

2. The Winner's Curse
The winning bid in an auction often exceeds the intrinsic value of the item purchased - maybe
due to increased bid aggressiveness as more bidders enter the market
3. Equity Premium Puzzle
CAPM says investors with riskier investments should get higher returns - but not so much!

Shares historically return 10% and government (risk free) bonds 3% - yet shares are not over 3
times more risky - so why is the return premium so high?

Behavioural finance shows people have a loss aversion tendency- so are more worried by losses
in comparison to potential gains - so in fact a very short-term view on an investment. 

So shareholders overreact to the downside changes. 

Therefore, it is believed that equities must yield a high-enough premium to compensate for the
investor's considerable aversion to loss.
Key concepts of Behavioural Finance

1. Anchoring
We tend to "anchor" our thoughts to a reference point - especially in new situations 

Large Coffee - £5
Medium Coffee - £3.50
Small Coffee - £3
The large is the anchor - get you used to a price (with no logic behind it) thus now making the
medium seem cheap. Especially as small (another anchor) is £3.

A share falls in value from £80 to £30 - it now seems a bargain - but that’s just not rational - you
need to see the fundamentals of WHY the price fell not just look at the £80 anchor
 2. Mental Accounting
Individuals assign different functions to each of their assets, often irrationally.

So a fund set aside for a vacation or a new home, while still carrying substantial credit card debt
is crazy (if the debt is costing more than the deposit account)

Some investors divide their investments between a safe and a speculative portfolio - all this work
and money spent separating the portfolios, yet his net wealth will be no different than if he had
held one larger portfolio.
3. Confirmation Bias
We all have a preconceived opinion. 

So we selectively filter and pay more attention to information that supports our opinions, while
ignoring the rest

An investor "sees" information that supports her original idea and not the contradictory info

4. Gambler's Fallacy
You've flicked a coin 10 times - it’s always been heads amazingly. 

What’s the chances of it being Tails on the next throw?

A gambler MAY incorrectly use the past info to try and predict the future. This is crazy. The
chance is still 50%

Some investors sell after a share has risen many times in the recent past - surely it can't continue
going up? Of course it can - the past has no effect on the future in these situations

5. Herd Behaviour
We mimic the actions (rational or irrational) of a larger group. 

Why else would anyone choose BPP or Kaplan over us?? :)

Individually, however, most people would not necessarily make the same choice.

The common rationale that it's unlikely that such a large group could be wrong. After all, even if
you are convinced that a particular idea or course or action is irrational or incorrect, you might
still follow the herd, believing they know something that you don't. This is especially prevalent
in situations in which an individual has very little experience.

Think about investors in many dot.com companies in the past - all following each other when
fundamentally the businesses were not strong

6. Overconfidence
74% of professional fund managers believe they deliver above-average job performance! :)

Overconfident investors generally conduct more trades than their less-confident counterparts.

Overconfident investors/traders tend to believe they are better than others at choosing the best
stocks and best times to enter/exit a position. 

Unfortunately, traders that conduct the most trades tended, on average, to receive significantly
lower yields than the market.
7. Overreaction Bias
One consequence of having emotion in the stock market is the overreaction toward new
information.  According to EMH semi strong markets, new information should more or less be
reflected instantly in a security's price. 

For example, good news should raise a business' share price accordingly, and that gain in share
price should not decline if no new information has been released since.

Reality, however, tends to contradict this theory. 

Often, participants in the stock market predictably overreact to new information, creating a
larger-than-appropriate effect on a security's price. 

Furthermore, it also appears that this price surge is not a permanent trend - although the price
change is usually sudden and sizable, the surge erodes over time.