Behavioral Finance and Market Behaviour

Some persistent market patterns such as momentum, value, bubbles, and crashes impact market efficiency and are regarded as functions of behavioral finance.

Market Anomalies

Anomalies are noticeable departures from the efficient market hypothesis, as evidenced by persistently aberrant returns. For instance, an anomaly such as misclassifications may stem from statistical problems, choice of asset pricing model, or temporary disequilibria.

There are ways of explaining some anomalies. Such ways include the analysis of the small sample sizes used, statistical bias in sample selection, survivorship bias, or data mining. It is also important to note that that the benchmark choice is paramount in determining the magnitude of any over or underperformance.

Momentum

When future price behavior aligns with that of the recent past, this is known as momentum or trending effects. Before reverting to the mean, the favorable association typically lasts about two years.

Availability, hindsight, and loss aversion biases can all contribute to momentum.

Regret is the feeling one experiences after missing out on an opportunity. It is often a manifestation of hindsight bias, reflecting the human predisposition to see past events as foreseeable. Thanks to regret, investors may feel an overwhelming urge to act emotionally not to miss out on the next big momentum play.

Bubbles and Crashes

Some bubbles may be products of sensible and logical reasoning. For instance, short-term performance-driven investment managers may attribute their decision to participate in a bubble to further advance their careers.

Bubbles excite confidence in investors. This leads to such anomalies as overtrading, underestimation of risks, failure to diversify, and rejection of any piece of information that contradicts their assessment of the market.

Excessive trading and overconfidence are connected to confirmation bias and self-attribution bias, contributing to a bubble. When a bubble bursts, markets may underreact due to anchoring. This occurs when investors fail to quickly update their beliefs.

Values

High book-to-market equity, low price-to-earnings ratios, and low price-to-dividend ratios are common characteristics of value stocks. High price-to-earnings ratios, low book-to-market equity, and high price-to-dividend ratios are distinguishing characteristics of growth stocks.

Behavioral reasons for value anomalies have been proposed in studies, such as in the Fama–French three-factor model (1993), portraying the anomalies as mispricing rather than compensating for greater risk. Less sophisticated investors who are easily driven by emotions may place a higher value on growth stocks.

Question

 Which of the following is most likely a characteristic of value stocks?

1. Low book-to-market equity.
2. Low price-to-dividend ratio.
3. High price-to-earnings ratio.

The correct answer is B

Value stocks are usually characterized by high book-to-market equity, low price-to-earnings ratios, and low price-to-dividend ratios.

 A and C are incorrect. They are both characteristics of growth stocks. Growth stocks are characterized by high price-to-earnings ratios, low book-to-market equity, and high price-to-dividend ratios.