How biases show up in markets: momentum, bubbles and value

What counts as an anomaly?

A market anomaly is an apparent deviation from the efficient market hypothesis: a persistent abnormal return that differs from zero and is predictable in direction. Behavioral finance treats many anomalies as the sum of individual biases across many investors.

Not every apparent deviation is a true anomaly. Misclassification comes from three sources.

Apparent anomalya persistent, predictable abnormal return

• Choice of asset pricing model Memorize change the model of normal returns and it disappears
  • Compensation for risk not abnormal at all
• Statistical issues Memorize the data misled
  • Small samples a pattern that does not repeat
  • Selection or survivorship bias only the survivors are studied
  • Data mining spurious correlations treated as real
• Temporary disequilibrium Memorize lasts years, then fades
  • Publication attracts arbitrage that removes the pattern

• The model of normal returns. “Abnormal” only has meaning against a definition of “normal”. If a reasonable change of asset pricing model makes the pattern disappear, it was an illusion. A persistent high return may also just be compensation for risk.
• Statistics. Small samples, selection or survivorship bias, and data mining that treats chance correlations as real. The choice of benchmark can change the size of any out- or underperformance.
• Temporary disequilibrium. Odd patterns can last for years, yet publication draws attention and arbitrage, which tends to remove them. Several well-known calendar patterns have weakened this way once they were adjusted for risk or widely published.

Which biases sit behind which pattern?

Three patterns are worth knowing, each with its own set of biases. The sections below take them in turn.

Behavioral explanationsindividual biases added up across many investors

• Momentum (trending) Memorize winners keep winning for a while
  • Availability (recency) extrapolate recent returns
  • Hindsight and regret fear of missing out
  • Loss aversion winners sold too soon, losers held too long
  • Herding follow the crowd
• Bubbles and crashes Memorize prices far from value, then collapse
  • On the way up overconfidence, confirmation, self-attribution, regret aversion
  • On the way down anchoring, cognitive dissonance, then capitulation
• Value effect Memorize value has beaten growth over long periods
  • Halo effect good company assumed to be a good investment
  • Overconfidence overestimated growth rates
  • Home bias familiar and nearby companies favored

Why does momentum happen?

The momentum effect is the tendency for recent winners to keep winning, and recent losers to keep losing. The positive correlation typically lasts up to about two years, followed by a reversal toward the mean over a longer period.

Behavioral explanations stack up:

• Availability, or the recency effect. The recency effect is the tendency to recall recent events more vividly and give them undue weight. When a price rises for a while, investors extrapolate the rise. Private investors do this more than professionals, many of whom expect reversion to the mean.
• Hindsight and regret. Regret is the feeling that an opportunity was missed, and it is often an expression of hindsight bias, the belief that the move was predictable. Investors who regret not owning last year’s winner try to remedy it by buying, which contributes to year-on-year trends and overtrading.
• Loss aversion, which slows the selling of losers and speeds up the selling of winners.
• Herding. Herding is following the crowd, as safer for reputation. It comes from regret aversion and strengthens trends.

Why do bubbles and crashes happen?

Bubbles and crashes challenge market efficiency: prices run far from value, then fall quickly. Behavioral finance does not yet give a full explanation, but certain biases are visible.

On the way up, investors show overconfidence: overtrading, underestimating risk, failing to diversify and rejecting contradictory information. More trading lowers expected profit and raises volatility. Overconfidence is fed by confirmation bias and self-attribution: in a rising market most sales show a profit, which feels like proof of skill. Regret aversion draws in the investors who feel they are missing out.

On the way down, markets can underreact at first because of anchoring: investors do not update enough. Cognitive dissonance makes them ignore losses and rationalize earlier decisions. Eventually investors capitulate, which accelerates the fall.

Some bubbles may also have rational elements. Rational investors may expect a crash without knowing its timing. Arbitrage can be limited by the cost of selling short, unwillingness to bear extended losses, or lack of suitable instruments. Managers judged on short-term performance may join the rally because of commercial or career risk.

Step through the five phases (stealth, rising enthusiasm, euphoria, denial, capitulation) and read which biases dominate each one.

Why might value beat growth?

Growth stocks have a high P/E, a low book-to-market ratio and a high price-to-dividend ratio. Value stocks have the opposite profile: low P/E, high book-to-market and low price-to-dividend. Over long periods value stocks have often outperformed growth stocks. This is the value anomaly .

There are two kinds of explanation. In a risk explanation, the premium vanishes in a three-factor asset pricing model, so it may reflect compensation for the greater chance of distress in downturns. In a behavioral explanation, growth stocks are overpriced:

• The halo effect extends a favorable view of some characteristics to others. A company with a good growth record and strong past share price is assumed to be a good investment, with higher expected returns than its risk justifies. This is a form of representativeness: past performance is extrapolated into expected returns.
• Overconfidence about growth rates can overvalue growth stocks.
• Home bias is a preference for domestic securities in a global portfolio, or for companies headquartered nearby. It can reflect a perceived informational advantage, comfort with access to management, or a wish to invest in a local community.
• Emotional attraction to a stock is boosted by its products, brand, marketing and proximity. Many investors behave as if risk and expected return were negatively related, expecting higher returns from stocks that feel safe, which contradicts standard theory.

Exam tip Momentum: recency. Bubbles: overconfidence. Value: halo and home.

Go deeper Limits to arbitrage

If mispricing exists, rational traders should trade against it and remove it. They do not always manage to. Shorting is costly, arbitrageurs may have to bear losses for a long time before a price returns to value, and suitable instruments may not exist. Clients who judge managers on short-term results make it riskier to bet against a trend. Mispricing can therefore persist, which is why behavioral explanations are plausible alongside the efficient market hypothesis.

Go deeper Where this meets market efficiency in Equity

The Equity topic covers the forms of market efficiency and the documented anomalies in detail. This lesson is the behavioral side of the same discussion: what individual biases could aggregate into. The key exam habit is the same in both places, check whether the pattern survives a better model of normal returns before accepting it as an anomaly.