UNIT II

MARKET ANOMALIES
 ANOMALIES: Meaning

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.
TYPES OF ANOMALIES
 SIZE ANOMALIES
Some authors have demonstrated that smaller companies (that is, the ones with smaller
market capitalization) tend to outperform larger firms. A company’s economic growth is
bound to its stocks performance, and the smaller firms grow more easily than the larger
ones.
Example: Let’s imagine a big company that needs over $6 billion to achieve a 10% growth
rate, while a smaller company needs only $60 million extra sales for obtaining the same
growth rate. Therefore, smaller companies are able to grow faster than larger companies,
and that is reflected on their stocks.
Small-caps outperform large-caps, especially during market rises, but at the expense of
increasing the portfolio risk.
Momentum Anomaly
Momentum is the rate of acceleration of a security's price or volume—that is, the speed at
which the price is changing. Simply put, it refers to the rate of change on price movements
for a particular asset and is usually defined as a rate. In technical analysis, momentum is
considered an oscillator and is used to help identify trends.

Investors can use momentum as a trading technique. Once a momentum trader sees
acceleration in a stock's price, earnings or revenues, the trader will often take a long (buy)
or short position (sell) in the stock in the hope that its momentum will continue in either
an upward or downward direction. This strategy relies on short-term movements in a
stock's price rather than fundamental value.

When applied, an investor can buy or sell based on the strength of the trends in an asset's
price. If a trader wants to use a momentum-based strategy, he takes a long position in a
stock or asset that has been trending up. If the stock is trending down, he takes a
short position.
Think of it as the momentum of a train. When a train starts, it accelerates but
moves slowly. In the middle of the trip, it stops accelerating but travels at a
higher velocity. At the end of the trip, the train decelerates as it slows down. For
the momentum investor, the best part of the train ride is in the middle, when
the train is moving at its highest velocity.

Momentum investors like to chase performance. They attempt to achieve alpha

returns by investing in stocks that trend one way or another. Stocks trending up
are referred to as hot stocks. Some are hotter than others as measured by
growth over a period of time. A stock that is trending down is cold.
Reversal Anomaly
A reversal is a change in the price direction of an asset. A reversal can occur to the
upside or downside. Following an uptrend, a reversal would be to the downside.
Following a downtrend, a reversal would be to the upside. Reversals are based on
overall price direction. Certain indicators, such a moving average or trend-lines,
may help in spotting reversals.
 Excessive Volatility Anomaly

Excess volatility across psychological aspects of investors is exhibited in the form of two
biases i.e. Overconfidence and Herding.
Robert Shiller's 'Market Volatility' proposes that investor reactions, due to psychological or
sociological beliefs, exert a greater influence on the market than good economic sense
arguments. He believes that investor attitudes are of great importance in determining price
levels (Schiller). His book provides statistical evidence that excess volatility exists in the
stock market and therefore volatility cannot be totally explained by the EMH. Excess
volatility is the name given to that level of volatility over and above that which is predicted
by efficient market theorists. In Shiller's eyes this excess volatility can be attributed to
investors' psychological behaviour. He claims that substantial price changes can be
explained by a collective change of mind by the investing public which can only be
explained by its thoughts and beliefs on future events, i.e. its psychology.
Aaccording to Shiller, people act inappropriately to information that they receive. He says
that investor behaviour depends on ex-post values, which is the value of an asset taking
into account the future dividends. By definition though, ex-post values cannot be known
ahead of the payment of dividends and so if future dividends are expected to be high
then the ex-post value today will also be high. So if investors knew the future dividend
then forecasting the future price (Pt) would present no problem, according to the EMH,
using ex-post values (Pt*):
Pt = EtPt*

In other words price equals the best possible forecast or expectation of ex-post values.
The excess volatility is addressed fully in an article by Shiller in the 1981 June issue of
'The American Economic Review' entitled, simply 'Do Stock Prices Move Too Much To Be
Justified By Subsequent Changes In Dividends?'. He proves that stock market volatility in
prices is five to thirteen times higher than the volatility which would be explained by the
EMH and new information.
In support of Shiller's work is the fact that, at the same time as he was writing his article
and totally independent of him, two economists, Stephen Le Roy and Richard Porter
were conducting a study which had virtually the same conclusions as those of Shiller.
They published their work in 'Econometrica' of May 1981 under the title 'The Present-
Value Relation: Tests Based on Implied Variance Bounds'. In this study, which was an in-
depth statistical study of excess volatility, Le Roy and Porter observed that based on
aggregated and disaggregated data, stock prices are more volatile than the efficient
capital markets model would suggest. This again lends more weight to Shiller's theory
of the importance of popular models.