DARANG, ANGELICA B.

BSBA FM 3-2
BEHAVIORAL FINANCE

LESSON#5: BEHAVIORAL FINANCE: MARKET ANOMALIES

 Market Anomalies: Defined and Explained

In finance, anomaly happens when the actual result differs from what is the
expected result under a given premises of assumption. The anomaly gives
evidence that a certain assumption cannot be fully relied-on since it resulted
different from what is expected. According to many researches, there are
different possible causes of these anomalies just like how new information is not
adjusted quickly, different tax treatments, as well as the behavioral preferences
or constraints of the investors. Anomalies usually tend to disappear when made
to be known publicly since it is addressed quickly and taking necessary action to
prevent it from surfacing or occuring again in the market.

 Behavioral Finance explanation of Market Anomalies

There are two common types of anomalies in finance, these are the market
anomalies and pricing anomalies. Market anomalies are deviations in returns that
contradict the efficient market hypothesis (EMH). Pricing anomalies are when
something, just like for example, a stock is priced differently than how a model
predicts it will be priced. Also, in 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 systematically be
predicted.

 The Trading Market Anomalies :

 The Calendar Effect -

o Monday Effect- This states that returns on the stock market
on Mondays will follow the same trend from the previous
Friday. In short, if the market was at its peak on Friday, then
it will also be of the same trend when the Monday comes.
The Monday effect is also known as the “weekend effect.”
 Turn-of-the-Month- The turn-of-the-month effect refers to the
tendency of stock prices to rise on the last trading day of the
month and the first three trading days of the next month.
The September effect- This is attributed to weak stocks market
returns for the Month of September. It is believed that investors
usually liquidate their stocks in this month of September.
January Effect- The January effect refers to the tendency of
stocks to return much more in the month of January than in the
other months. The January Effect is a widely known market
anomaly whereby stock prices tend to regularly rise in the first
month of the year. Actual evidence of the January Effect is
small, with many scholars arguing that it does not really exist.
Holiday Effect- The holiday effect is one of the most widely
analyzed calendar anomalies in stock markets. Its best known
aspect refers to the observed fact that stock returns typically
have consistent patterns around holidays, with higher returns on
days before going to big or major holidays. Holiday effect is
described as a totally predictable effect of the stock exchange
closing due to national holidays.

 Post Earnings-Announcement Drift

The Post-Earnings-Announcement Drift (PEAD) is one of the most

puzzling anomalies in finance. This anomaly refers to the fact that
companies reporting unexpectedly high earnings subsequently outperform
companies reporting unexpectedly low earnings. This anomaly is often
called the ‘SUE-effect’, for standardized unexpected earnings (others call
it the ‘earnings momentum effect’).

 Momentum Effect
The momentum effect is a market anomaly in which many finance
theories struggle to explain. The mentioned difficulty is that, an increase
in asset prices, in and of itself, should not guarantee the further increase.
Additionally, according to efficient-market hypothesis, increase in assets
should be widely based on the accumulated new information regarding on
that specific asset. Supply and demand also plays an imperative role
when analyzing the value of a specific asset. Researchers have also
attributed this momentum to cognitive biases, which belongs to the
 behavioral economics. It explains that, investors are usually irrational,
meaning, they act according to their biases and are slow to incorporating
new information when engaging to their investment or in the financial
market.

 Value Effect

This is one of the most well-known fundamental anomalies in the

financial market. It 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. Meaning, investors are willing to invest in
that low book value stocks and embracing all the risks attached on this
specific investment.
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 claims
are inevitably true, the value effect sees traders behaving the opposite
way and to accept practice and buying shares that are technically
overvalued.

 Heuristics and Biases

 The History and Origin of Heuristics

This was further developed in the 1970s- 1980s by the psychologists

Amos Tversky and Daniel Kahneman, although the main concept had
been originally introduced by the Nobel laureate Herbert A. Simon.
Simon’s original idea of the research was problem solving that showed
how we operate and react within what he calls bounded rationality. He
also coined the term satisficing, which means a situation in which people
seek solutions, or accept choices or judgements, that are already “good
enough” to serve their purposes although they could still be optimized.

 How Heuristics are Used

 In its simplest definition, Heuristics is the process in which people use
short cuts to arrive at a specific decision. This is a strategy that humans
use to quickly form judgements and to quickly find solutions to complex
problems. Oftentimes, it involves focusing on the most relevant aspect of
the problem to be able to eliminate quickly the other irrelevant factors
regarding in a given specific situation. It allows quick formulation of the
solutions in a specific problem.

Since heuristic processes are used to find the answers and solutions
that are most likely to work or be correct, they are not always right or the
most accurate. Judgments and decisions based on heuristics are simply
good enough to satisfy a pressing need in situations of uncertainty, where
information is incomplete. In that sense they can differ from answers given
by logic and probability.

 Types of Heuristics
There are so many types of Heuristics. Below are some of the most
observed ones.
 Educated guess. This means that a person reaches a conclusion
without applying exhaustive research. With an educated guess a
user considers what they have observed in the past, and applies
that history to a situation where a more definite answer has not yet
been decided.
 Absurdity. An approach to a situation that is not so typical and
unlikely – in other words, a situation that is absurd. This particular
heuristic is applied when a claim or a belief seems silly, or seems to
defy common sense.
 Consistency. The person responds to a situation in way that
allows him to remain consistent.
 Contagion. Causes the person to avoid something that is thought
to be bad or contaminated in a larger scale or even in the whole
community. For example, when meats are recalled due to meat
bacteria outbreak, a person might apply this simple situation and
decide not to buy that specific contaminated meat altogether to
prevent sicknesses.
 Familiarity. This is when a person decides to approach a problem
based on the fact that the situation is one which the person is
familiar with, and that he should act the same way he acted in the
same situation in the past.
  Authority. It occurs when a person believes the opinion of a
person with authority in a specific field is what he should follow on.
For example, you follow the suggestions given by a popular person.

 How Heuristics can Lead to Biases

Since Heuristics can contribute to stereotypes and prejudice, it is

therefore essential that people should first apply an extensive research
before deciding and arriving in their judgements or decisions. Because
people use mental shortcuts to classify and categorize people and the
situation, they often overlook more relevant information and create
stereotyped categorizations that are oftentimes not useful in the reality.

 Importance of Using Heuristics in Decision Making

While it is true that Heuristics approach provides an immediate

reaction or solution to a specific problem, people should be wary and
mindful of the proper process or approach before arriving to their
judgements or solutions. Investors should be keen to informations
available in the market for them not to fall prey in the short-cut schemes
that eventually may lead to unfavorable situation. It is indeed essential to
make extensive research before undertaking in a specific investment
opportunity.