Behavioral finance FAQ / Glossary (Anomaly)

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Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

(market) Anomaly


 

01/5i - 02/7i - 04/2i,5d,6i
- 05/5i,6i + see behavioral
biases,
price anomaly, EMH,
inefficiency, collective bias,
fair value,asymmetry.

Something wrong with the price
if compared to the norm?

Or something wrong with the norm?

Definition (general):
    An anomaly is as a state of things that does not fit an usual norm.
    A zebra in the horse race!

Definition (finance):

What is commonly called a
financial market anomaly (*) is
        an asset price or return (**) that
diverges from some standard paradigm.

Typically, such a discrepancy contradicts the EMH / Efficient Market
Hypothesis (see that phrase).

(*) Also called inefficiency (see that word), imperfection,
      distortion
or also, as a more neutral and factual name

effect (see also that word).

That last appellation tries not to give opinion on how weird,
harmful or unconsequential either the phenomenon ...or the
paradigm might be.

(**) Anomalous price rises or falls translate into anomalous (negative
       positive) returns
.

The main component of an asset return is its price change
(except maybe for bonds or, in some degree, for real estate).

What are the usual criteria to call "anomalous"
     
or a financial situation?

Unrealistic ...realities?

Or abnormal ...norms?

There is a paradox in qualifying quite real situations as anomalous,
and even more if those purported anomalies are frequent.

That ambiguity might come from the criteria used.

What are usually considered as market anomalies
are discrepancies / divergences between
current market realities and:

What is given as the "fair value" (*), or "fair return"

by theoretical economic / financial models
designed to take into account the assets' "fundamentals".

In the economic field, the optimal allocation
   of resources.

(*) At least in the economic sense of that phrase (see "value" in the
     
glossary),   as there is some semantic ambiguity: "fair value" is

      also used in accounting  as a term based mostly on the market price.

The EMH / RWH references,
      the theoretician's shop window.


In financial asset markets, the usual reference are the models based on the
EMH
/ Efficient market hypothesis (see that phrase).

Anomalies are then defined as:

Differences of returns - and the related mispricing
(see price anomaly)
that are spotted when comparing
market returns and prices to what those models predict.

Another common reference (closely related to the EMH) is the
RWH / Random walk hypothesis .

It states that things evolves according to a normal random distribution
law (see distribution).

The flaw is that, in economics and finance, evolutions
do not fully follow such "laws".

The discrepancies / anomalies from the RWH are shown in data clusters,
fat tails, asymmetries, percolation thresholds, cumulative bifurcations and
other phenomena seen in this glossary.

To sum it up, are those criteria
     fully relevant to spot anomalies?

Can they help you detect, on the market crime scene,
evidences of financial anomalies and find a use for them?


Anyway, in reality, anomalies, unless blatant, are hard to define, to spot
and to measure (*).

This is because the theoretical models used as references (**)

might be themselves ...anomalous, at least partially.

(*) And thus, for an investor, hard to be used for its own advantage!

Those models do not always help to detect anomalies with certainty
so as not to invest in overpriced assets (see overpricing).
It is even less easy to correct them to find what is the "true" value

(**) Even behavioral finance refers to the EMH instead or looking for
        its own valuation theory
(with a few exceptions: see "behavioral

pricing").

Some sees this as one of weaknesses of BF in its present state.

Are return and price anomalies common or rare?
    
Temporary or persistent?

Just occasional market gaffes?

Or the ordinary and repetitive market way of life?


The idea behind the word "anomaly" is that the famous "invisible hand" suffers
occasional clumsiness.

But the question arises about those purported gaffes: Occasional?
Or common and recurrent?

1) Occasional anomalies (short lived anomalies)

In some periods, or in some types of assets, anomalies are rare and/or get
quickly corrected, as soon as some traders see an opportunity
of  "arbitrage" (see that word).


Those mild and transient discrepancies do not contradict fundamentally
the EMH paradigm behind the model.

They also fit what most of those models consider as simple "volatility" (see
that word).without much explanation about its origin,

2) Persistent anomalies (long term anomalies)

Some anomalies are recurrent and / or persistent,

or are corrected in ...anomalous ways.

In those cases, which seem rather frequent and widespread, distorting
phenomena researched by behavioral finance are at play. This includes:

Some so-called persistent "market effects" (see P/E effect
    for example),

Many market trends (uptrends, downtrends), which
    persistance
raises questions about the quality of previous - or

future -anticipations,

All extreme price variations (bubbles, crashes), showing

exaggeration (positive feedback) instead of correction / regulation
(negative feedback)

Some price stickiness , on the other hand,

Various other phenomena due to imperfect markets, or individual

and collective / cognitive and emotional "biases" (see below),

Behavioral finance tries to describe, and as far as possible explain
those phenomena that diverge, in a persistent way, from random
distribution laws (see distribution)

In reality, anomalies seem to be all over the place.

Sometimes we might wonder if a lack of anomalies
would not be ...anomalous.

Thus, the EMH might be a theory that only describes idealized cases that are
never reached.

If total efficiency / inefficiency happens only in borderline cases,
we should talk about "degrees of efficiency".

In that case, the EMH is a tentative approximation that reflects and
explains the market only in some degree.

What causes market anomalies?

Officer, what was wrong?
The map? The car? The driver?


Anomalies, defined again as market deviations from standard theoretical
values, seem to have three main causes :

1) Imperfect market structures.

Clogged pipes

In general, nearly all markets are imperfect, with (minor or big) built
in obstacles that prevent a "perfect competition"
.

In none of them, the law of supply and demand works without
glitch.

None really has the ideal structure which meets the conditions
that textbooks exact of "perfectly competitive" markets.

But some markets get nearer that blissful state than others.

* Organized financial assets markets, the big stock exchanges for
   example,
are said to be closer to perfect competition than other
   economic markets.

* The main commodity markets are also considered as such.

But even so, all those markets have some structural imperfections.

Those markets' main structural imperfection lies in
"asymmetries", the fact that investors have
different information (and financial strengths).

Examples:
big hands vs. little hands, institutions vs. the general public, etc.

Another imperfection can be a lack of transaction volume and
liquidity.

2) Collective / contagious behavioral biases.

Blind crowds

One or a few person's behavioral biases cannot really change the
market course.

The incidences on markets becomes sizeable only
when those biases become collective
, and affect a
large or powerful enough mass of investors or traders.

Those behavioral biases (see that phrase), whether cognitive or
emotional, individual or collective, are the bread and butter of this
glossary.

Herding is the most typical of those collective biases that distort
market prices.

Well, the words anomaly and bias are sometimes interchangeable.

You are also welcome to use "flaws", "blunders" or even more
picturesque terms.

3) Not to be neglected, oversimplifications in the

standard market theories used as a comparison
basis.

Kids in the lab

Those theories and models, whatever the Greek letters
on the blackboard, might be more or less biased:

In the best cases by poorly realistic assumptions,

In the worst cases by framing, reductionism, representativeness

heuristics (see those phrases) or whatever cognitive bias.

Yes, models themselves might be built on cognitive biases.
See "model".

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

Members of the BF Group, please
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This page last update: 20/09/15  

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