What is an 'Anomaly'

Anomaly is a term describing the incidence when the actual result under a given set of assumptions is different from the expected result. An anomaly provides evidence that a given assumption or model does not hold in practice. The model can either be a relatively new or older model. In finance, two common types of anomalies are market anomalies and pricing anomalies. Market anomalies are distortions in returns that contradict the efficient market hypothesis. Pricing anomalies are distortions in pricing given a certain set of assumptions used in a pricing model.

BREAKING DOWN 'Anomaly'

Anomaly is a term describing an event where actual results differ from results that are expected or forecasted based on models. Two common types of anomalies in finance are market anomalies and pricing anomalies. Common market anomalies include the small cap effect and the January effect. Anomalies often occur with respect to asset pricing models, in particular, the capital asset pricing model (CAPM). Although the CAPM was derived by using innovative assumptions and theories, it often does a poor job of predicting stock returns. The numerous market anomalies that were observed after the formation of the CAPM helped form the basis for those wishing to disprove the model.

Although the model may not hold up in empirical and practical tests, that is not to say that the model does not hold some utility.

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