By Albert Phung

The presence of regularly occurring anomalies in conventional economic theory was a big contributor to the formation of behavioral finance. These so-called anomalies, and their continued existence, directly violate modern financial and economic theories, which assume rational and logical behavior. The following is a quick summary of some of the anomalies found in the financial literature.

January Effect
The January effect is named after the phenomenon in which the average monthly return for small firms is consistently higher in January than any other month of the year. This is at odds with the efficient market hypothesis, which predicts that stocks should move at a "random walk". (For related reading, see the Financial Concepts tutorial.)

However, a 1976 study by Michael S. Rozeff and William R. Kinney, called "Capital Market Seasonality: The Case of Stock Returns", found that from 1904-74 the average amount of January returns for small firms was around 3.5%, whereas returns for all other months was closer to 0.5%. This suggests that the monthly performance of small stocks follows a relatively consistent pattern, which is contrary to what is predicted by conventional financial theory. Therefore, some unconventional factor (other than the random-walk process) must be creating this regular pattern.

One explanation is that the surge in January returns is a result of investors selling loser stocks in December to lock in tax losses, causing returns to bounce back up in January, when investors have less incentive to sell. While the year-end tax selloff may explain some of the January effect, it does not account for the fact that the phenomenon still exists in places where capital gains taxes do not occur. This anomaly sets the stage for the line of thinking that conventional theories do not and cannot account for everything that happens in the real world. (To read more, see A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

The Winner's Curse
One assumption found in finance and economics is that investors and traders are rational enough to be aware of the true value of some asset and will bid or pay accordingly.

However, anomalies such as the winner's curse - a tendency for the winning bid in an auction setting to exceed the intrinsic value of the item purchased - suggest that this is not the case.

Rational-based theories assume that all participants involved in the bidding process will have access to all relevant information and will all come to the same valuation. Any differences in the pricing would suggest that some other factor not directly tied to the asset is affecting the bidding.

According to Richard Thaler's 1988 article on winner's curse, there are two primary factors that undermine the rational bidding process: the number of bidders and the aggressiveness of bidding. For example, the more bidders involved in the process means that you have to bid more aggressively in order to dissuade others from bidding. Unfortunately, increasing your aggressiveness will also increase the likelihood in that your winning bid will exceed the value of the asset.

Consider the example of prospective homebuyers bidding for a house. It's possible that all the parties involved are rational and know the home's true value from studying recent sales of comparative homes in the area. However, variables irrelevant to the asset (aggressive bidding and the amount of bidders) can cause valuation error, oftentimes driving up the sale price more than 25% above the home's true value. In this example, the curse aspect is twofold: not only has the winning bidder overpaid for the home, but now that buyer might have a difficult time securing financing. (For related reading, see Shopping For A Mortgage.)

Equity Premium Puzzle
An anomaly that has left academics in finance and economics scratching their heads is the equity premium puzzle. According to the capital asset pricing model (CAPM), investors that hold riskier financial assets should be compensated with higher rates of returns. (For more insight, see Determining Risk And The Risk Pyramid.)

Studies have shown that over a 70-year period, stocks yield average returns that exceed government bond returns by 6-7%. Stock real returns are 10%, whereas bond real returns are 3%. However, academics believe that an equity premium of 6% is extremely large and would imply that stocks are considerably risky to hold over bonds. Conventional economic models have determined that this premium should be much lower. This lack of convergence between theoretical models and empirical results represents a stumbling block for academics to explain why the equity premium is so large.

Behavioral finance's answer to the equity premium puzzle revolves around the tendency for people to have "myopic loss aversion", a situation in which investors - overly preoccupied by the negative effects of losses in comparison to an equivalent amount of gains - take a very short-term view on an investment. What happens is that investors are paying too much attention to the short-term volatility of their stock portfolios. While it is not uncommon for an average stock to fluctuate a few percentage points in a very short period of time, a myopic (i.e., shortsighted) investor may not react too favorably to the downside changes. Therefore, it is believed that equities must yield a high-enough premium to compensate for the investor's considerable aversion to loss. Thus, the premium is seen as an incentive for market participants to invest in stocks instead of marginally safer government bonds.

Conventional financial theory does not account for all situations that happen in the real world. This is not to say that conventional theory is not valuable, but rather that the addition of behavioral finance can further clarify how the financial markets work.

Next: Behavioral Finance: Key Concepts - Anchoring »

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