Level 1 CFA® Exam:
Influence of Behavioral Biases on Market Behavior
A market anomaly is a deviation of asset prices that appears to contradict the basic principles of efficient financial markets. Anomalies are often associated with behavioral biases, which lead investors to make irrational decisions.
There are many different types of market anomalies, but some of the most common are:
- momentum anomalies,
- bubble & crashes, and
- value anomalies.
The momentum (aka. trending effects) is the tendency for assets that have performed well in the recent past to continue to outperform in the future, and vice versa.
In the case of bubbles and crashes, we observe prices rise to unsustainable levels and then crash.
Value anomalies can be observed for example in the case of the performance of value stocks relative to growth stocks. Also, other factors like the halo effect or home bias can be used to explain value anomalies.
Please note that market anomalies can lead to market inefficiencies and opportunities for investors to make money.
The momentum (aka. trending effects) is the tendency for assets that have performed well in the recent past to continue to outperform in the future, and vice versa.
In various markets, a positive correlation between future prices and recent past prices can be observed. However, this positive correlation doesn’t last forever and reversion to the mean can also be observed.
Biases explaining momentum effects: availability bias (recency effect), hindsight bias, loss aversion bias
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The value effect is the tendency for stocks with low price-to-earnings ratios, high book-to-market equity, and low price-to-dividend ratios (aka. value stocks) to outperform the stocks with high price-to-earnings ratios, low book-to-market equity, and high price-to-dividend ratios (aka. growth stocks).
Value effect = tendency for value stocks to outperform growth stocks
Please note that the value effect could be, at least partially, explained by 3- or 4- factor CAPM models, like Fama & French 3-factor model. Value anomalies can also be explained using behavioral finance theory. Value anomalies can be attributed to different factors, including the halo effect and the home effect.
The halo effect is the tendency for investors to overvalue stocks that e.g. have been doing well recently or have a good growth record. Under the halo effect, investors expect future returns to be higher than it would be rational to expect based on merit.
The biases that are behind the halo effect include representativeness and overconfidence.
The home effect is the tendency for investors to overvalue stocks of companies that are based in their home country. This is often due to a positive bias towards companies that are familiar to investors.
Level 1 CFA Exam Takeaways: Influence of Behavioral Biases on Market Behavior
star content check off when done- There are many different types of market anomalies, but some of the most common are: momentum anomalies, bubble & crashes, and value anomalies.
- The momentum (aka. trending effects) is the tendency for assets that have performed well in the recent past to continue to outperform in the future, and vice versa.
- Biases identified during bubbles and crashes include: overconfidence bias, overtrading, confirmation bias, self-attribution bias, and hindsight bias.
- The value effect is the tendency for stocks with low price-to-earnings ratios, high book-to-market equity, and low price-to-dividend ratios (aka. value stocks) to outperform the stocks with high price-to-earnings ratios, low book-to-market equity, and high price-to-dividend ratios (aka. growth stocks).