Behavioral Finance - Class 5 (Anomalies explained by Behavioral Finance)

What is a market anomaly?

An apparent deviation from the Efficient Market Hypothesis (EMH), identified by persistent abnormal returns that differ from zero and are predictable in direction. They are inconsistent with the EMH.

What are three statistical explanations for anomalies?

1. Small samples involved. 2. Statistical bias in selection or survivorship. 3. Data mining that overanalyzes data and treats meaningless correlations as relevant (e.g. butter production in Vietnam correlating with S&P 500 returns).

What is temporary disequilibrium behavior?

Unusual market features that may survive for years but ultimately disappear. Examples: the small company January effect (disappears after risk adjustment) and the weekend effect (lower Monday returns, which has since reduced).

What are bubbles and crashes?

Bubbles are periods of unusual positive asset returns because prices deviate significantly above intrinsic value. Crashes are periods of unusual negative returns as prices revert to intrinsic value. They appear to be panics of buying and selling driven by collective irrationality.

What causes asset price bubbles?

A continuous rise in asset prices fueled by investors' expectations of further increases, causing prices to become decoupled from economic fundamentals.

What behavioral biases drive bubbles?

1. Overconfidence: overtrading, underestimation of risk, illusion of knowledge. 2. Confirmation bias: rejecting contradictory information. 3. Self-attribution bias: taking personal credit for gains. 4. Regret aversion (FOMO): fear of missing out on profit opportunities as prices rise.

What behavioral biases drive crashes?

1. Hindsight bias: investors deceive themselves they predicted the crash. 2. Anchoring: causes underreaction as bubble unwinds — investors don't update beliefs sufficiently. 3. Disposition effect: investors hold on to losers and postpone regret.

According to Shiller, how can you spot a bubble?

Check for: sharply rising asset prices, public excitement about price increases, media frenzy, stories of common people getting rich, growing general public interest, 'new era' theories justifying high valuations, and declining lending standards.

What is the Momentum anomaly?

The tendency for future price behavior to positively correlate with recent past performance in the short term (up to 2 years), but negatively correlate (mean revert) over longer periods of 2–5 years. Documented by Jegadeesh and Titman (1993).

What did the Dimson, Marsh & Staunton (2008) momentum study find?

In the UK over 52 years to 2007: top-performing stocks over the past 12 months subsequently returned 18.3% annualized vs. 6.8% for worst performers vs. 13.5% for the market. The momentum effect was also found in 16 other international markets.

What are the S&P 500 momentum statistics (Gerber, Hens & Vogt, 2010)?

Monthly autocorrelation of the S&P 500 is +0.28. If the S&P 500 rises in a month, probability of rising again next month = 63% (avg return 0.11%). If it declines, probability of declining again = 48% (avg return 0.06%).

What is herding behavior?

When a group of investors trade on the same side of the market in the same securities, or when investors ignore their own private information and follow other investors instead.

What behavioral biases explain the momentum anomaly?

1. Short-term underreaction to earnings news (linked to anchoring and conservatism bias). 2. Longer-term overreaction once news is incorporated. 3. Gamblers fallacy: belief that assets revert to long-term mean explains mean reversion. 4. Availability bias / recency effect: weighting recent events too heavily. 5. Regret aversion: feeling of missing opportunities (linked to hindsight bias). 6. Disposition effect: holding losers causes slow reaction to declines in true value (Shefrin & Statman, 1985).

What is the recency effect?

A form of availability bias where investors recall recent events more vividly and give them undue weight in their decision making.

What is the Value vs. Growth anomaly?

Value stocks (high book-to-market equity) have consistently outperformed growth stocks (low book-to-market equity) over long periods. Fama and French (1998) found value outperformed growth in 12 of 13 major markets from 1975–1995.

Why does the Value vs. Growth anomaly exist according to behavioral finance?

Investors systematically overpay for companies with good stories and strong past performance (growth stocks) and underpay for companies with bad recent histories (value stocks). Value stocks outperform because they were undervalued to begin with.

What is the Halo Effect in investing?

A form of representativeness bias where a company with a good growth record and strong past share price performance is seen as a good investment with higher expected returns than its actual risk characteristics justify. Investors extrapolate past performance into expected future returns.

What is the Home Bias anomaly?

Investors prefer familiar stocks due to personal experience, strong brands, advertising, or geographic proximity to the company. It is a form of availability bias (categorization).

What did Statman, Fisher & Anginer (2008) find about popular stocks?

Stock returns of funds rated as popular in Fortune magazine surveys were subsequently low — investors systematically overpay for companies with good stories, creating the value vs. growth anomaly.

What is Post-Earnings Announcement Drift (PEAD)?

The phenomenon where stock prices do not immediately adjust to earnings surprises. Instead they drift: stocks with positive earnings surprises continue to drift upward after the announcement, and stocks with negative surprises continue to drift downward.

What are the empirical statistics behind PEAD?

Over the 60 days following an earnings announcement, stocks with the largest positive surprise returned 2% more than peers. Stocks with the largest negative surprise returned 2% less than peers. The effect was more than twice as large for small-cap and mid-cap firms.

What behavioral biases explain PEAD?

Analysts underreact to earnings announcements when adjusting quarterly forecasts. This is explained by: 1. Anchoring and adjustment bias (insufficient updating from prior estimate). 2. Conservatism bias (slow to update beliefs with new information).

What is the long-term reversal pattern in earnings surprises?

Short term: positive earnings surprises tend to be followed by further positive surprises. Long term (about 1 year): positive surprises tend to be followed by negative surprises and vice versa — this represents overreaction.

What is the Equity Risk Premium Puzzle?

The observation that stock returns have historically been far higher than risk-free returns, and the difference cannot be justified by traditional rational asset pricing models. The mean log return of the S&P 500 is approximately 4% higher than short-term commercial paper.

Who first identified the Equity Risk Premium Puzzle?

Hansen and Singleton (1983) and Mehra and Prescott (1985).

How do Benartzi and Thaler (1995) explain the Equity Risk Premium?

Through two psychological concepts: 1. Myopic loss aversion: investors avoid stocks due to fear of short-term losses, pushing stock prices lower than they should be. 2. Narrow framing: investors focus on short-term returns rather than long-term performance.

What is myopic loss aversion?

The tendency to evaluate investment performance too frequently (short-term perspective), which amplifies the emotional impact of losses and causes investors to avoid equities even when long-term returns would justify holding them.

What is ambiguity aversion and how does it relate to the equity risk premium?

Ambiguity aversion is people's dislike of situations where outcomes are uncertain and hard to measure (like stocks). Faced with this uncertainty, investors focus on worst-case scenarios and demand higher returns — contributing to the equity premium puzzle.

What is the Volatility Puzzle?

The observation that historical stock price volatility is far greater than can be explained by rational models with constant discount rates. West (1988) found the variance of surprises in stock prices was 4–20 times the theoretically predicted upper bound.

Who first introduced the Volatility Puzzle?

Shiller (1981) and LeRoy and Porter (1981).

What behavioral biases explain the Volatility Puzzle?

1. Herding behavior: amplifies price movements, increasing volatility. 2. Ambiguity aversion: uncertainty leads to larger, more frequent price swings. 3. Hindsight bias: investors think past movements were predictable, causing them to underestimate actual volatility.

What is the Disposition Effect?

The tendency of investors to sell winning investments too early (to lock in gains) and hold onto losing investments too long (to avoid realizing losses). It is driven by loss aversion and causes slow reaction to declines in an asset's true value.

What is self-attribution bias?

A cognitive bias where investors take personal credit for investment successes (attributing gains to their own skill) while attributing losses to external factors. It is a faulty learning model that contributes to bubble formation.

What is narrow framing?

The tendency to evaluate investments in isolation and focus on short-term outcomes rather than viewing them as part of a broader long-term portfolio context. Contributes to the equity risk premium puzzle.

What is the gamblers fallacy in investing?

The mistaken belief that assets will revert to their long-term mean after a run of performance, causing investors to underreact to trends in the short term and contributing to mean reversion behavior.

What are the 5 main market anomalies covered in this course?

1. Bubbles and Crashes. 2. Momentum. 3. Value vs. Growth. 4. Post-Earnings Announcement Drift (PEAD). 5. Equity Risk Premium Puzzle. (+ Volatility Puzzle)

What is the key literature for momentum?

Jegadeesh and Titman, 1993. Also Dimson, Marsh and Staunton, 2008 and Shefrin and Statman, 1985 (disposition effect and mean reversion).

What is the key literature for the Equity Risk Premium Puzzle?

Mehra and Prescott (1985); Benartzi and Thaler (1995) for the behavioral explanation.

What is the key literature for the Volatility Puzzle?

Shiller (1981); LeRoy and Porter (1981); West (1988).

What is the key literature for Value vs. Growth?

Fama and French (1998); Statman, Fisher and Anginer (2008).

What is the key literature for PEAD?

Santa Clara et al., 2008. The behavioral explanations draw on anchoring (Tversky & Kahneman) and conservatism bias.

What are Mark Sellers' 7 traits of a successful investor?

1. Buy when others panic, sell when others are euphoric. 2. Obsessive about the game and wanting to win. 3. Willingness to learn from mistakes. 4. Inherent sense of risk based on common sense. 5. Confidence in convictions even under criticism. 6. Use both sides of the brain (analytical and intuitive). 7. Ability to live through volatility without changing investment process.

What does Mark Sellers say is the source of competitive advantage for investors?

Psychology — it is hardwired into your brain and you can't change it even by reading books. Competitive advantage comes from managing your psychological biases better than others.

What is the SUE formula used in PEAD research?

SUE = (Actual Earnings − Expected Earnings) / Standard Deviation of Expected Earnings. A higher SUE indicates a larger positive earnings surprise.

What is the EAR formula used in PEAD research?

EAR = (Price after announcement − Price before announcement) / Price before announcement. It measures the immediate stock price reaction to an earnings announcement.