Question

What are some of the anomalies to the Efficient Market Hypothesis?

Answer 1

Market anomalies are market patterns that do seem to lead to unusual returns more often than not. In financial markets, anomalies refer to situations when a security or group of securities performs contrary to the notion of efficient markets, where security prices are said to reflect all available information at any point in time.

The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information. Furthermore, because future stock prices follow a random walk pattern, they cannot be predicted. However, there does seem to be some market patterns that can lead to abnormal returns, thus violating the efficient market hypothesis, particularly the semi-strong EMH, which predicates that abnormal returns cannot be earned by learning all the available public information on companies and their stocks, and any other variables that may affect stock prices, such as economic factors.

Three generally accepted anomalies to the Efficient Market Hypothesis are (1) the size effect, (2) the valuation effect and (3) the momentum effect.

1. Research on the size effect shows that companies with smaller market capitalization have historically outperformed those with large market capitalization, even after controlling for their higher risk.

2. Research on the valuation effect shows that companies with low price/book (P/B) multiples have historically outperformed those with higher P/B multiples.

3. Research on the momentum effect shows that companies that have performed the best over the past six months to one year tend to perform better than the set of companies that have performed the worst over a similar period.