Market Characteristics Not Explained by Traditional Finance

In a truly efficient market, no new information should lead to the generation of alpha, defined as returns in excess of the market. Markets are not always truly strong-form efficient. Indeed, some anomalies that seem to contradict the efficient market hypothesis have been observed.

Momentum Effect

In short, a momentum effect is similar to a trend. Stock prices have been observed for as long as two years of having a positive correlation with each other, after which they tend to reverse course and become negatively correlated.

Markets often operate based on fear and greed, creating a herding effect. Another potential element is availability bias, which means investors give more credence to more visible data. This often manifests in the extrapolation of recent or widely available data into a forecast at the expense of less visible data.

Hindsight bias causes investors to look at the past and feel they should have been able to foresee past events. However, this is only bolstered by a new and complete picture derived from the present moment. This can misguide investors’ future investment decisions, as they fail to see and account for their limitations.

Bubbles and Crashes

Like trend-chasing behaviors and the momentum effect, bubbles, and crashes involve irrational market forces taking control and pushing asset prices to new highs or lows not justified by logic or company fundamentals. The effects of bubbles and crashes tend to be much more severe than simple trends and can be challenging for some investors to see until it is too late. Unlike trends, bubbles, and crashes refer to asset prices that fluctuate by more than two standard deviations from their mean. The following biases may be prevalent in bubbles and crashes:

1. Overconfidence may exacerbate bubbles by leading to excessive trading.
2. Self-attribution bias may also perpetuate bubbles as investors look to credit themselves for their ex-post performance rather than attributing the changes to external forces.
3. Hindsight bias is closely related to self-attribution bias regarding bubbles and crashes. Investors may be encouraged to keep adding risk and trading excessively when they reflect on recent portfolio increases and attribute them to their investing acumen.
4. Regret aversion bias can promote bubbles as investors look around and see other investors making gains and decide they don’t want to miss out.
5. The disposition effect occurs when investors hold onto their losers too long and sell their winners too quickly. This behavior is driven by a desire to be right, leading to the excessive trading of winning stocks.

Value vs. Growth Investing

Value Stocks have low P/E ratios, high book-to-market ratios, and generally higher dividends. Fundamental analysts focus on finding stocks offered at a discount to their intrinsic value.

Growth Stocks have the opposite attributes of value stocks – high P/E ratios, low book-to-market ratios, and typically low to no dividends. Investors purchase these stocks, hoping to come across an up-and-coming firm with a bright future. Rather than focusing on investing in these stocks at a discount to intrinsic value, growth investors only care that the stock price will increase from its current level.

Growth investing can equate to trend-following, while value investing is often synonymous with going against a trend or investing as a contrarian.

Studies have found that value stocks tend to outperform growth stocks across various markets and time frames. This mispricing anomaly may be due to various firm sizes and their vulnerabilities to economic downturns – smaller means more vulnerable. Growth stocks and value stocks are often subject to different risk factors.

The Halo effect refers to the tendency to extrapolate one or more positive attributes of a company onto other facets of the same company, such as stock price. For example, a company involved in charitable endeavors may be more likely perceived by biased investors as a good investment, even though those two attributes may or may not be related.

The home bias effect refers to a tendency of investors to over-focus on local markets at the expense of properly considering and examining foreign opportunities. Portfolios containing home bias will likely move away from the optimal portfolio as the modern portfolio theory would prescribe.

Question

Which kind of stock does having a high book-to-market value most accurately describe?

1. Small-cap stocks.
2. Growth stocks.
3. Value stocks.

Solution

The correct answer is C:

Value stocks are known for having high book-to-market value ratios. A value stock may be more reflective of a manufacturing firm or retailer with a high inventory level or assets on hand.

A is incorrect: Growth stocks are not mature in their life cycles and often have more intangible assets than tangible assets – think tech firms with patents, codes, and human capital as their main assets.

A value stock may be more reflective of a manufacturing firm or retailer that keeps a high level of inventory or assets on hand.

Reading 2: Behavioral Finance and Investment Processes

Los 2 (g) Describe how behavioral biases of investors can lead to market characteristics that may not be explained by traditional finance