Economics Term Paper

In the world of investment, an anomaly refers to a strange event occurrence. From the financial markets perspective on the other hand, an anomaly refers to a state where a security orgroup of securities’ register a performance that is contrary to efficient markets notion. An asset market is regarded to be efficient when the prevailing prices are in a position of reflecting all the available information at a given time. Considering the rapid dissemination and constant release of new information, it is at times difficult to achieve efficient markets and also more difficult to ensure that they are maintained. There are several asset market anomalies and some of them occur once after which they disappear. Others are howeverobserved continuously. Some given tradeable anomalies are persistent in a stock market and this fascinates many investors.

While asset market anomalies are worth being explored, it is imperative for investors to appreciate the fact that anomalies can disappear, re-appear and appear with no warning at all. Consequently, following any kind of a trading strategy can become very risky. There are 7 types of asset market anomalies which is imperative for all investors to be aware of. They include: January effect, small firms tending to outperform big firms, firms having low book values tending to have a market outperformance, neglected stocks tending to outperform broad market averages, reversals, days of a week anomaly, and finally is the dogs of a Dow anomaly (Lee et al, 1990). This paper aims to discuss the role of asset market anomalies in financial analysis from the perspective of behavioural finance and asset market efficiency.

Central aspects of behavioural finance theories

Behavioural finance is a branch of behavioural economics which proposes theories that are based on psychology so as to offer explanations on anomalies in the stock market, like severe increases or decreases instock prices. The aim here is to ensure that we get to identify and comprehend the reasons why people come up with certain financial choices (Assness et al, 2014). Under behavioural finance, the assumption which ismade is that the structure of information and the features of the market participants do influence the market outcomes and investment decisions that people make in a systematic manner.

The central aspects of behavioural finance theories are anchored on the idea that the stock market follows some random walk where investors want to have the highest possible utility regardless of the risk that they might undergo during the process. Considering the fact that there is a lot of information that is available to investors, with this information flowing at a fast rate, this has made it very complicated for decision makers to arrive at one decision in the financial markets.

Behavioural finance theories seek to offer an understanding and prediction of the systematic asset market implications to psychological decision making processes. The theories closely combine market phenomena and individual behaviour and employs the knowledge that is obtained from both the financial theory and the field of psychology. The overall intention of these theories is to try to ascertain how investors behave in the process of trying to ensure that they maximise their wealth using the limited resources that they have.

Behavioural finance versus orthodox finance

Investment advisors usually use the analysis of behavioural finance to understand the investment needs and the needs of their clients as well. Behavioural finance is imperative in the process of portfolio management since it has an influence on capital allocation and asset investment choices that are made by investors. This makes it to be a more successful method of studying asset market anomalies.

Orthodox finance focuses on the manner in which an individual should behave. In this case, individuals are regarded to be “rational economic individuals”. This translates to a market where the prevailing prices do reflect all the relevant information that is available (Richard et al, 2013). Behavioural finance on the other appreciates the fact that the manner in which information is relayed to the investor has an influence on how he makes a decision and this can therefore lead to cognitive and emotional biases. This way, behavioural finance is also said to be more successful in studying asset market anomalies. The main focus of behavioural finance is to ascertain the reasons why an investor chooses to behave in a given way. Considering that the decisions of investors are not optimal at all times, this leads to the development of markets which are persistently or temporarily inefficient.

Behavioural finance can be broken down into macro and micro financial assessment. Micro behavioural finance is concerned with individual persons. It tries to offer explanations regarding to why an individual decides to deviate from orthodox finance theory.Macro behavioural finance on the other hand is concerned with financial markets. It tries to offer explanations regarding to the reasons why markets get deviated for the efficient markets.

Orthodox finance derives its basis from the neoclassical economics. The basic assumptions that are made in the orthodox finance include: individuals have a perfect function of utility, they focus on the maximization of their personal utility functions and are also risk averse by nature. Therefore, “rational economic individuals” lead to the creation of efficient markets.

According to orthodox finance, rational investors have four rules which include:

  • That is he is aware of all the preferences that exist.
  • That is they do apply their preferences in a consistent manner.
  • That is these rankings are proportional and additive.
  • Continuity: This implies that they have continuous indifferent curves. There are also unlimited weights combinations that can be possibly made.

Orthodox finance is usually based on the utility theory where an assumption of decreasing marginal returns is made. This has an implication that the shape of risk averse utility functions is concave. The diminishing substitution rates makes the indifference curves to be convex in shape (William,2010). Behavioural finance on the other hand recognizes the fact that individuals can at times have both risk seeking and risk averse behaviours therefore qualifying it to be a more successful method of studying anomalies compared to orthodox finance.

Bounded rationality is a very important concept in behavioural finance. It states that limitations exist in the manner in which individuals process information that they have been provided with. This then removes the perfect information assumption that is given consideration in orthodox finance. Instead, individuals tend to practice satisfice that develops outcomes which give sufficient satisfaction rather than optimal utility.

The Role of Asset Market Anomalies in Financial Analysis from the Perspective of:

  1. Asset market efficiency

Asset market efficiency is the degree in which the prevailing market prices do reflect all the relevant, available information. When markets are regarded to be efficient, this implies that all the information has been captured in the prices, and therefore there is no approach of “beating “the market since there will be no over-or undervalued securities. The theory of efficient market hypothesis is directly linked to the concept of market efficiency. According to this theory, it is impossible for a single investor to be in a position of outperforming the market (Shleifer, 1999). The theory goes ahead to state that market anomalies must not be in existence since they will be arbitraged away immediately. Investors who buy the idea of this theory will always purchase index funds which track the overall performance in the market and they are also the proponents of a passive portfolio management.

In its centrality, asset market efficiency determines the ability of a market(s) to incorporate information which offers the maximum level of opportunities to sellers and buyers of securities so as to influence transactions without pushing the transaction costs up. There is sufficient empirical evidence showing that a wide spread of financial information has an effect on the prices of securities and also makes the financial markets to become more efficient. Financial statements have been regarded as being more credible therefore making information to become more reliable. This way, more confidence is generated in the price of a security as stated in the market.

Some other demonstrations of asset market efficiency come up when the perceived market anomalies tend to be widely known after which they disappear subsequently. For example, it once happened that a newly added stock to the stock exchange led to a significant boost to its share price just because it formed part and parcel of the existing index rather than as a result of new fundamental changes in the company. The index-effect anomaly then became widely known and reported, and since then it therefore disappeared mysteriously. This thus demonstrates that when there is a wide information access, markets consequently become increasingly efficient and with this, anomalies also get reduced.

There are 3 degrees of asset market efficiency. First is the weak-form of the asset market efficiency which has the assumption that past movements in price do not have any influence on the future rates. The second degree is the semi-strong asset market efficiency which assumes that stock prices adjust quickly so as to absorb new information which is available to the public (Jonathan et al, 2013). This way, an investor is not in a position of benefiting by utilizing the new public information. The third degree is the strong asset market efficiency which states that the market prices depicts all the information both private and public. This therefore implies that no investor even the one who has an access to insider information will be in a position of benefiting above an average investor.

The Role of Asset Market Anomalies in Financial Analysis from the Perspective of:

  1. Behavioural finance

The development of behavioural finance was prompted by the regular occurrence of asset market anomalies in the conventional theories of economics. The anomalies seemed to be directly violating the modern economic and financial theories which assumed a logical and rational behaviour among the participants (Shleifer, 2000). The examples below will illustrate the role of asset market anomalies in financial analysis from the perspective of behavioural finance.

  1. January effect.

According to this effect, the average monthly returns for small companies’ is constantly higher during the month of January compared to other months of the year. The January effect phenomenon is against the hypothesis of efficient markets, which provides that stocks must assume a random walk (Diamond et al, 2012). Conducting a financial analysis with this kind of anomaly therefore makes it difficult to come up with consistent results.

One empirical evidence that can be used to demonstrate the January effect anomaly is a case study which was done by Kinney and Rozeff between the period of 1904 and 1974. According to the results of this study, small firms realised average returns of 3.5% during the month of January while the average returns for the other months was registered at 0.5% only. This study suggested that monthly small stocks’ performance assumed a pattern which was relatively consistent. The consistency was not in line with the predictions which were provided for by the conventional theories of finance. Therefore, Kinney and Rozeff believed that there was an anomaly which was at play. The anomaly contributed to the above than average returns in the month of January from year to year.

There are some few explanations which have been used to offer explanations regarding to the January effect anomaly. One of the explanations is that the boost arises from the fact that investor’s dispose their dead end stocks during the month of December so that they can achieve tax losses. With this, returns tend to bounce back in the month of January and during this time, investors do not have an incentive of selling. This can be an imperative factor but there are other factors which come into play as well. The phenomenon indeed is still in existence in areas where there are no capital gain taxes.

  1. The winner’s curse.

The orthodox theory makes an assumption that investors are very rational and they can autonomously determine the actual value of assets therefore enabling them to pay or bid accordingly (Ivo, 2014).). Nonetheless, asset market anomalies suggest that the terms of this theory may not always hold. The anomaly that arises in this case is the “winner’s curse” anomaly.

The winners curse refers to a situation where the winning bid during the setting of an auction exceeds the asset’s actual intrinsic value. This is obviously contrary to the assumption that whatever is paid for by investors is the actual value that an asset has. The anomaly therefore makes it difficult for analysts to come up with actual estimates that assets will be sold at when they are conducting their financial analyses.

Orthodox financial theories make the assumption that the participants of the process of bidding have equal access to relevant information therefore enabling them to arrive at the same valuation of the respective assets that are being traded. This therefore implies that the disparities in pricing of the asset is as a result of factors that are not tied directly to the asset itself.

Richard Thaler who is a celebrated pioneer of behavioural finance came up with an article in 1988 which highlighted on the winner’s curse. According to this article, there are two factors that undermine the process of bidding in an asset market. The factors are: how aggressive the bidding process is and the total number of bidders who are participating in the bidding process (Barberis et al, 2005). He went on to further claim that, the greater the number of bidders who are involved during the process of bidding, the more aggressive these bidders will be so that they can dissuade other individuals from bidding. This implies that, when the aggressiveness in which bids are being placed is increased, there will be high chances that the winning bid is going to exceed the actual value of the item that is being traded.

A real-life illustration of the anomaly caused by the winner’s curse is seen in the process of potential house-buyers bidding for houses. Even thoughthere is a possibility that the parties that are involved in this process are very rational and are aware of the true value of the home that they want to purchase based on the sales prices of same types of homes in the recent past, it is still possible to experience some valuation errors. The error can occur as a result of variables like bidders’ aggressiveness and the number of the bidders coming into play. Empirical evidence during financial analysis have shown that the selling price of a house is usually 25% high and above its actual value. In this illustration, the curse manifests itself in 2 ways: the winning bidder has not only considerably overpaid, but the purchaser will also have a difficult time in securing a financing.

  • Equity premium puzzle.

The equity premium puzzle is among the most puzzlinganomalies of orthodox financial theory. According to the CAPM model, investors who hold more risky financial assets must be given higher return rates as their compensations (Hens et al, 2008). Long-term financial analyses have shown that the real returns of government bonds on average is approximately 3% while that of stocks is 10% on average. The equity premium of 7% between these two assets is extremely big and it implies that stocks are riskier to hold as compared to bonds. However, according to the conventional economic models, the premium must be much lower than it is currently. This disconnect between the empirical results and theoretical models is still a major puzzle that has to be dealt with.

A solution to this equity premium puzzle has been proposed by behavioural finance. According to this solution, investors should not react to the short term losses that an asset might have since it is a normal thing. They should rather consider the long term gains that will be realised from the asset. The theorists of behavioural finance believe that equities should yield sufficient premiums that can compensate the risk aversion behaviour of investors. This therefore implies that equity premium is regarded as amotivation to the market playersand this makes them to invest in stocks rather than the safer government bonds.

Conclusion

This paper has clearly demonstrated the role of asset market anomalies in financial analysis from the perspectives of behavioural and asset market efficiency. The anomalies identified in the behavioural finance help in the explanation of the reasons why investors behave in given ways when they are making their decisions. This paper has also clearly demonstrated that markets do not operate efficiently as expected due to reasons such as information asymmetry. Both the orthodox and the behavioural financial theories do complement each other when seeking clarifications regarding to why different financial transactions are conducted in given ways rather than being conducted in ways that are stipulated by the provided theoretical models.

References

Assness, C. et al. (2014). “Fact, Fiction and Momentum Investing”, Journal of Portfolio Management, fall 2014 – pre-publication version available online.

Barberis, N. &Thaler, R. (2005). “A Survey of Behavioural Finance”, chapter 1 of Thaler, RH. (Ed) Advances in Behavioural Finance, vol. II, Princeton University Press, chapters 12, 13, and 14.

Diamond, P. & Vartiainen, H. (2012). Behavioural Economics and Its Applications. Princeton University Press. ISBN 1-4008-2914-

Hens, T. & Bachmann, K. (2008). Behavioural Finance for Private Banking. Wiley Finance Series. ISBN 0-470-77999-3.

Ivo, W. (2014). Corporate Finance (3rd Edition). ISBN 978-0-9840049-1-1.

Jonathan, B. & Peter, D. (2013). Corporate Finance (3rd Edition). Pearson. ISBN 0132992477.

Lee, C.Shleifer, A. & Thaler, R. (1990). “Anomalies: closed-end mutual funds”, Journal of Economic Perspectives, vol.4 (4), pp. 153–64.

Richard, B. Stewart, M. & Franklin, A. (2013). Principles of Corporate Finance. McGraw-Hill. ISBN 978-0078034763.

Shleifer, A. (2000). Inefficient Markets: An Introduction to Behavioural Finance, Oxford University Press.

William, L. (2010). Practical Financial Management. South-Western College Pub; 6 ed. ISBN 1-4390-8050-X.