IFT Notes for Level I CFA® Program
R38 Market Efficiency
4. Market Pricing Anomalies
A market anomaly is something that challenges the idea of market efficiency. Some anomalies observed in the market are:
4.1. Time-Series Anomalies:
- Calendar anomalies: The returns in January are higher than in any other month, especially for small firms. This phenomenon is known as the January effect.
- Momentum and overreaction anomalies: Investors overreact to events or release of unexpected public information.
4.2. Cross-Sectional Anomalies:
- Size effect: Small-cap stocks tend to perform better than large-cap stocks.
- Value effect: Value stocks tend to perform better than growth stocks.
4.3. Other Anomalies:
- Closed-end investment fund discounts: Closed-End investment funds sell at a discount to NAV.
- Earnings surprise: Investors can earn abnormal profits by buying stock of companies with positive earnings surprise and selling those with negative earnings surprise.
- IPOs: Prices rise on listing day, but underperform in the long term.
- Predictability of returns based on prior information: Research has found that equity returns are related to prior information such as interest rates, inflation rates, stock volatility, and dividend yields.
In practice, it is not easy to trade and benefit from anomalies. Most research concludes that anomalies are not violations of market efficiency, but are the result of statistical methods used to detect anomalies.
Many anomalies might simply be a result of data mining. At times researchers carefully analyze data and form a hypothesis. This is the opposite of what should happen. Ideally, a hypothesis should be formed and then the data should be analyzed to accept or reject the hypothesis.
5. Behavioral Finance
Behavioral finance uses human psychology to explain investment decisions. Some irrational behavior and biases observed in the market are:
- Loss aversion: Investors dislike losses more than they like gains of the same amount.
- Herding: In herding, investors ignore their private information and act as other investors do.
- Overconfidence: Overconfident investors do not process information. They place too much confidence in their ability to process and analyze information and, thus, value a security.
- Information cascades: Information cascade is when people observe the actions of a handful of market participants and blindly follow their decisions. The informed participants act first and their decision influences the decisions of others.
Other behavioral Biases
- Representativeness: Investors with this bias will assess probabilities based on events seen before, or prior experiences, instead of calculating the outcomes.
- Mental accounting: Investors divide investments into separate mental accounts, they do not view them as a total portfolio.
- Conservatism: Investors tend to be slow to react to changes.
- Narrow framing: Investors focus on issues in isolation.
Behavioral Finance and Investors
Behavioral biases affect all investors irrespective of their experience. An understanding of behavioral finance will help individuals make better decisions, both individually and collectively.
Behavioral Finance and Efficient Markets
If investors must be rational for efficient markets, the existence of behavioral biases implies that the markets cannot be efficient. If the effects of the biases did not cancel each other out, then the markets could not be efficient. But, since investors are not making abnormal returns consistently, the markets can be considered efficient. Evidence supports market efficiency. In other words, markets can be considered efficient even if market participants exhibit seemingly irrational behavior.