Module 5.

1: Capital Market Efficiency –

Market Anomalies & Behavioural Finance
Explanations

I. K. Dontwi

Jan 2018
 MARKET PRICING ANOMALIES
 A market anomaly occurs if a change in the price of an asset or security cannot
directly be linked to current relevant information known in the market or to the release
of new information into the market

 The anomalies are placed into categories based on the research method that identified
the anomaly;

Time-series anomalies were identified using time series of data.

Cross-sectional anomalies were identified based on analyzing a cross
section of companies that differ on some key characteristics.
Other anomalies were identified by a variety of means, including event
studies.
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 • Anomaly Categories

1. Time-Series Anomalies
• Two of the major categories of this that have been documented are;
 Calendar anomalies; is most frequently observed for the returns of small market
capitalization stocks.
Momentum and overreaction anomalies; relate to short-term share price
patterns.
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 2. Cross-Sectional Anomalies
• Two of the most researched cross-sectional anomalies in financial markets are;
 Size effect: results from the observation that equities of small-cap companies tend
to outperform equities of large-cap companies on a risk-adjusted basis
Value effect: results when value stocks that have below-average price-to-earnings
(PIE) and market-to-book (M/B) ratios, and above-average dividend yields, have
consistently outperformed growth stocks over long periods of time.
3. Other Anomalies
Closed-End Investment Fund Discounts: A closed-end investment fund issues a
fixed number of shares at inception and does not sell any additional shares after
the initial offering.
Therefore, the fund capitalization is fixed unless a secondary public offering is
made

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 Earnings surprise: is the portion of earnings that is unanticipated by investors and,
according to the efficient market hypothesis, merits a price adjustment.
Positive (negative) surprises should cause appropriate and rapid price increases
(decreases)
Initial Public Offerings (IPOs): when a company offers shares of its stock to the
public for the first time, it does so through an IPO.
This offering involves working with an investment bank that helps price and
market the newly issued shares.
Implications for Investment Strategies
• Although it is interesting to consider the anomalies just described, attempting to benefit
from them in practice is not easy.
• In fact, most researchers conclude that observed anomalies are not violations of
market efficiency but, rather, are the result of statistical methodologies used to
detect the anomalies

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 MARKET PRICING ANOMALIES
• A market anomaly occurs if a change in the price of an asset or security
cannot directly be linked to current relevant information known in the
market or to the release of new information into the market.

• The anomalies are placed into categories based on the research method that
identified the anomaly;
 Time-series anomalies were identified using time series of data.

Cross-sectional anomalies were identified based on analyzing a cross section of

companies that differ on some key characteristics.

Other anomalies were identified by a variety of means, including event studies.

6
 • Anomaly Categories

1. Time-Series Anomalies
• Two of the major categories of this that have been documented are;
 Calendar anomalies; is most frequently observed for the returns of small market
capitalization stocks.
Momentum and overreaction anomalies; relate to short-term share price
patterns.
7
 2. Cross-Sectional Anomalies
 Two of the most researched cross-sectional anomalies in financial markets
are;
 Size effect: results from the observation that equities of small-cap companies tend
to outperform equities of large-cap companies on a risk-adjusted basis.

Value effect: results when value stocks that have below-average price-to-earnings
(PIE) and market-to-book (M/B) ratios, and above-average dividend yields, have
consistently outperformed growth stocks over long periods of time.

3. Other Anomalies
Closed-End Investment Fund Discounts: A closed-end investment fund issues a
fixed number of shares at inception and does not sell any additional shares after the
initial offering.
 Therefore, the fund capitalization is fixed unless a secondary public offering is made
8
 Earnings surprise: is the portion of earnings that is unanticipated by investors
and, according to the efficient market hypothesis, merits a price adjustment.
 Positive (negative) surprises should cause appropriate and rapid price increases (decreases)

Initial Public Offerings (IPOs): when a company offers shares of its stock to the
public for the first time, it does so through an IPO.
 This offering involves working with an investment bank that helps price and market the newly
issued shares.
Implications for Investment Strategies
• Although it is interesting to consider the anomalies just described,
attempting to benefit from them in practice is not easy.

• In fact, most researchers conclude that observed anomalies are not violations of
market efficiency but, rather, are the result of statistical methodologies used to
detect the anomalies
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 BEHAVIORAL FINANCE
• Behavioral finance is a field of financial thought that examines investor
behavior and how this behavior affects what is observed in the financial
markets.
• The behavior of individuals, in particular their cognitive biases, has been
offered as a possible explanation for a number of pricing anomalies.
• In a broader sense, behavioral finance attempts to explain why individuals
make the decisions that they do, whether these decisions are rational or
irrational.
• Most asset-pricing models assume that markets are rational and that the
intrinsic value of a security reflects this rationality.
• But market efficiency and asset-pricing models do not require that each individual is
rational-rather, only that the market is rational.
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Behavioural Biases used to explain pricing anomalies
1. Loss Aversion: Behavioral theories of loss aversion allows for or assumes the
possibility of uneven (not symmetrical) dislike for risk by investors; such that investors
dislike losses more than they like comparable gains (DeBondt and Thaler, 1985).

 Such theories are believed to explain market overreactions that are observed. However, there is
also evidence of prevalence underreactions as there are overreactions, which tend to counters the
arguments for overreactions
2. Overconfidence (Hubris): The theory says overconfident investors place too
much emphasis on their ability to process and interpret information about a security,
yet they often do not process and interpret information well.
• It normally occurs:
 after success.
 and partially due to illusion of knowledge.
o This refers to the tendency for people to believe that the accuracy of their forecasts increases
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with more information.
 Overconfidence..contd
• Overconfidence causes people to overestimate their knowledge, risks and their ability
to control events.
Even without information, people believe the stocks they own will perform better
than stocks they do not own.

• Overconfidence can lead investors to poor trading decisions which often manifest
themselves as excessive trading, risk taking and ultimately portfolio losses.

• The portfolios of overconfident investors will have high risk for two reasons:
 First is the tendency to purchase higher risk stocks. The second is a tendency to under diversify
their portfolio.
 Prevalent risk can be measured in several ways: portfolio volatility, beta and the size of the firms
in the portfolio.

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 Overconfidence Cont’d
• Therefore a market with more overconfident investors will lead to security mispricing,
though temporary; and it is quite common in high growth companies because their
prices tend to react slowly to new information

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 Disposition effect
 Disposition effect; in which investors tend to avoid realizing losses but, rather, seek
to realize gains

When fear of regrets and pride seeking causes investors to be predisposed to

selling winners (potential stocks with growing market prices) too early and riding
or keeping losers (stocks with negative tendencies in market prices) too long.
This is called the disposition effect. Investors usually hold in their portfolios losers
remarkably longer than winners.

The disposition effect not only predicts selling of winners but also suggests that
winners are sold too soon and the losers are held too long.

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 Disposition effect
 The fear of regret and the seeking of pride can affect investors in two ways:

1. First, investors are paying more in taxes because of the disposition to sell to
winners instead of losers;

2. second, investors earn a lower return on their portfolio because they sell the
winners too early and hold poorly performing stocks that continue with
decreasing market results.

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 Perceptions of investment risk
• One important factor in evaluating a current risky decision is a past outcome:
people are willing to take more risk after earning gains and less risk after
losses.

• The house-money effect predicts that investors are more likely to purchase
higher-risk stocks after locking in a gain by selling stocks at a profit.

• After experiencing a financial loss, people become less willing to take a risk.
• This is called the snakebite effect.

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 Perceptions of investment risk Cont’d
• The endowment effect is when people demand more to sell things than they
would be willing to pay to buy it.

• A closely related endowment effect is the status quo bias behavior of the
people when they try to keep what they have been given instead of exchanging.
The status quo bias increases as the number of investment options increases.

• Memory also affects investors’ behavior. Memory can be understood as a

perception of the physical and emotional experience.
• Closely related with the memory problems affecting investors behavior is cognitive
dissonance.
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 Perceptions of investment risk Cont’d
• Cognitive dissonance is based on the evidence that people are struggling
with two opposite ideas in their brains.

• The avoidance of cognitive dissonance can affect the investor’s decision

making process in two ways:

First, investors can fail to make important decisions because it is too uncomfortable to
contemplate the situation;

second, the filtering of new information limits the ability to evaluate and monitor
investor’s decisions.

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 Mental accounting and investing
• Mental accounting, in which investors keep track of the gains and losses for
different investments in separate mental accounts.

Mental budgeting matches the emotional pain (cost) to the emotional joy (benefit). The
benefits of financial gains is like the joy of consuming gods and services.

Economic theories predict that people will consider the present and future costs and
benefits when determining the course of action.

People usually consider historic costs when making decisions about the future. This is
called the sunk-cost effect. The sunk cost could be characterized by size and timing.

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 Mental accounting and investing Cont’d
• The larger the amount of money invested, the stronger the tendency to keep-going. The
pain of closing a mental account without a benefit decreases with time; negative
impact of sunk cost depreciates over time.

• Mental accounting also affects investors’ perceptions of portfolio risks. The tendency to
overlook the interaction between investments causes investors to misperceive the risk
of adding a security to an existing portfolio.

• Mental accounting sets the bases for segregating different investments in separate
accounts and each of them considered as alone, evaluating their gains and losses.

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 Emotions and Investments
• Background feelings or mood may influence investment decisions. The mood
affects the predictions of the people about the future.

• People often misattribute the mood they are in to their investment decisions.
This is called the misattribution bias.

• Investors who are in good mood give a higher profitability of good events or
positive changes happening and a lower profitability of bad changes happening.

• A consequence of the optimistic investor is his decision to buy the stock which
is underestimated based on his calculations, when in reality it is not.
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 Emotions and Investments Cont’d
• An investor who is a bad mood may underestimate growth rate and stock
value based on his calculations shows the stock is overestimated, when it is
not in reality.

• Investors tend to be most optimistic when the market reaches the top and they
are most pessimistic when market is at the bottom.
• This fluctuating social mood is defined as market sentiment.

• A market bubble is explained by the situation when high prices seem to be

generated more by investors’ optimism then by economic fundamentals.

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 Other Behavioural Biases put forth to explain investor behaviour
and pricing anomalies
1. Representativeness, with investors assessing probabilities of outcomes depending on
how similar they are to the current state.
2. Gambler’s fallacy, in which recent outcomes affect investors’ estimates of future
probabilities.
3. Conservatism, where investors tend to be slow to react to changes.

4. Narrow framing, in which investors focus on issues in isolation

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 Behavioural Biases….
 The basic idea of the theories above is that investors are humans and,
therefore, imperfect and that the beliefs they have about a given asset’s
value may not be homogeneous.

 Though these behaviors help explain observed pricing anomalies one of

the key questions is:

• whether these insights help exploit any mispricing. In other words,

can researchers use investor behavior to explain pricing, or can
investors use it to predict how asset prices will be affected?
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 Applications of some other Behavioural Theories of: Personal
Learning, Information Cascades and Herding in Financial Markets
Application/Use:
For explaining generally patterns of observed pricing - and possible price
abnormalities – of or in securities (example: explaining possible serial correlation in
security returns).

Personal Learning suggests that investors learn by observing trading results and
through ‘conversations’ – ie sharing ideas about specific assets and markets among
investors
• This view argues that investors social interaction and the resulting contagion has an important
effect on security pricing; and explains security pricing anomalies ie it can explain price
changes without information and mistakes in valuation

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 Applications of Other Behavioural Theories of Personal Learning,
Information Cascades and Herding in Financial Markets
Information Cascade is the transmission of information from investors who act first and
whose market decisions influence other investors (who ignore their own information and
preferences) in making market decisions.

• This view argues that information cascade leads to serial correlation in stock returns which in is
consistent with market overreaction anomalies. A key question however is does information
cascade lead to correct pricing of securities?

• In answering this question, some argue (Avery and Zemsky, 1999) that if information cascade is
leading to incorrect pricing, the cascade is fragile and therefore will be temporal and will be
corrected by investors observing and following trades of well recognized informed traders or
better public information in the market. How do we reconcile this position with recent financial
crises?

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 Information Cascade contd….
Information Cascade is the transmission of information from investors who act first
and whose market decisions influence other investors (who ignore their own
information and preferences) in making market decisions.

• Information cascade does not necessarily mean investors can take advantage of it to make
gainful trades.

• Does information cascade lead rational behaviour in markets?..... Only if informed traders act
first for uniformed traders to imitate their trading behavior will there be rationality in trading
behaviour in the market; as it allows the market to incorporate relevant information into prices,
even through uniformed traders, hence making it efficient.

• Some evidence suggest that information cascade is stronger in firms with poor information
quality (Avery and Zemsky, 1999).

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 Applications of Behavioural Theories of Personal Learning,
Information Cascades and Herding in Financial Markets
Herding is clustered trading that may or may not be based on information. Where herding
occurs not based on information it is often termed spurious herding.

• A key distinction therefore between herding and information cascade is that information
cascade is driven at all times by information but herding may not be based on information.

• A key similarity is that both are consequences or results from behavioral biases such as
framing or mental accounting

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 Behavioural Finance & Efficient Markets
Behavioral theories have come to be recognized as offering alternative explanation to and
understanding of how markets function and how security prices are determined

However, whether there is a behavioral explanation to pricing anomalies generally

remains debatable – with both behavioural and rational statistical explanations being
offered.

• On the one hand, if investors must be rational for efficient markets to exist, then all the weakness of
human investors suggest that markets cannot be efficient.

• On the other hand, if all that is required for markets to be efficient is that investors cannot
consistently beat the market on a risk-adjusted basis, then the evidence does support market
efficiency.

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 Thank You

For any concerns, please contact

elearning@knust.edu.gh
elearningknust@gmail.com
0322 191132
Jan 2016