Gary Karz, CFA (email)
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The Value Line Anomaly
Psychology and Behavioral Finance
SummaryDespite strong evidence that the stock market is highly efficient, there have been scores of studies that have documented long-term historical anomalies in the stock market that seem to contradict the efficient market hypothesis. While the existence of anomalies is generally well accepted, the question of whether investors can exploit them to earn superior returns in the future is subject to debate. Investors evaluating anomalies should keep in mind that although they have existed historically, there is no guarantee they will persist in the future. If they do persist, transactions and hidden costs may prevent outperformance in the future (see the Value Line Anomaly and Implementation Shortfall). Investors should also consider tax effects in their taxable portfolios when evaluating stock strategies. Researchers that discover anomalies or styles that produce superior returns have two choices: (1) go public and seek recognition for discovering the technique; or (2) use the technique to earn excess returns (many do both). It's common for money to flow into strategies that attempt to exploit anomalies and this in turn causes the anomaly to disappear. Further, even anomalies that do persist may take decades to pay off. Investors evaluating historical data should also consider the potential pitfalls of "data mining." When searching large amounts of data, correlations between variables may occur randomly and therefore may have no predictive value. Anomalies that have existed over the longest time frames and have been confirmed to exist in international markets and out of sample periods are particularly persuasive. See also
- Dissecting Anomalies from Eugene Fama and Ken French (2008)
- Explaining Stock Returns: A Literature Review by James L. Davis (2001)
- Market Efficiency, Long-Term Returns, and Behavioral Finance from Eugene Fama (1997)
- The Efficient Market Hypothesis and It's Critics from Burton Malkiel (2003)
- Efficient Markets Hypothesis from Andrew Lo
- Information and the Efficiency of the Capital Markets from William Goetzmann's book
- What as Worked In Investing from Tweedy Browne was first published in 1992, and updated in 2009 with a few additional references to more recent studies.
Books of interest
- A Random Walk Down Wall Street
- A Non-Random Walk Down Wall Street
- What Works on Wall Street
- The New Finance: The Case Against Efficient Markets
- The Winnerís Curse: Paradoxes And Anomalies Of Economic Life
Selected Quotes on Anomalies
"All the statistics boil down to this: Too many investors are trying to find the next Home Depot. Too few are trying to find the next Chrysler. . . . There are at least three dozen academic studies showing the long-term superiority of value strategies."
David Dreman, Forbes 6/17/96.
"Graham's observations that investors pay too much for trendy, fashionable stocks and too little for companies that are out-of-favor, was on the money. . . . why does this profitability discrepancy persist? Because emotion favors the premium-priced stocks. They are fashionable. They are hot. They make great cocktail party chatter. There is an impressive and growing body of evidence demonstrating that investors and speculators don't necessarily learn from experience. Emotion overrides logic time after time."
David Dreman, Forbes 5/6/96.
"Because of bid-ask spreads, transactions costs, and the price impact of trading, investors most likely will not earn abnormal returns from following a value strategy. . . .We suggest that the increased marketing of style funds in the past two decades may have created an environment allowing funds to justify charging higher expenses. Higher fees and the price impact on trading smaller stocks appear to make the value premium unobtainable for the typical mutual fund investor. . . . We propose that the value premium is simply beyond the reach of investors."
Todd Houge and Tim Loughran in Do Investors Capture the Value Premium?, Financial Management, Summer 2006 (At SSRN)
"Fact is that most seasonal tendencies are only 'statistically significant' -- meaning you can write a dissertation on the subject, but don't try to make money on it. . . . Institutions, unlike most of you, close their books at the end of the year and tally up their gains and losses so they can prepare their report cards. If a stock has been the subject of bad news and has done poorly, they may throw it out, even if it is now a cheap stock; they don't want prospective investors to think they pick losers."
Laszlo Birinyi Jr., "The window dressing anomaly" Forbes, 12/20/93.
"Elaborate tests of the correlation of successive prices, runs, and filter rules find some weak relationships, but they are not sufficient to generate trading profits after taking account of transactions costs."
Graham and Dodd's Security Analysis, Fifth Edition. Sidney Cottle, Roger F. Murray, and Frank E. Block.
"Many can be explained away. When transactions costs are taken into account, the fact that stock prices tend to over-react to news, falling back the day after good news and bouncing up the day after bad news, proves unexploitable: price reversals are always well within the bid-ask spread. Others, such as the small-firm effect, work for a few years and then fail for a few years. Others prove to be merely proxies for the reward for risk taking. Many have disappeared since (and because) attention has been drawn to them. One example is the partial disappearance of the illogical discount on closed-end funds in America (known in Britain as investment trusts), since Princeton University's Burton Malkiel drew attention to it in his book A Random Walk Down Wall Street. The activities of traders exploiting an inefficiency cause it to disappear."
"Frontiers of Finance Survey," The Economist 10/9/93.
"The best time to buy is when blood is running in the streets."
Nathan M. Rothschild
"Most so-called anomalies don't seem anomalous to me at all. They seem like nuggets from a gold mine, found by one of the thousands of miners all over the world."
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