How to Beat The Market: Market Anomalies
On average, active investors underperform in the market. However, the long-last empirical research confirms that there are market anomalies that can generate outstanding returns. Although there is a strong belief in the efficient market hypothesis, where all prices reflect the available information, market anomalies are distortions in returns that can help to earn arbitrage profits.
The chief strategist at BCA Research, Peter Berezin says : “Anomalies persist even though people know about them. They may not be as potent as they once were, but still there”. Thus, there is definitely some room to exploit these opportunities.What are those anomalies, and how can a sophisticated or lazy investor gain on them? Here is the list of the most acknowledged anomalies that every investor could follow in order to outplay the market.
- Low beta stocks: According to the CAPM, high-beta stocks predict to bring higher expected returns as they are more risky. According to the data, this implication is not very convincing in reality - highly risky stocks underperform the market. One of the explanations could be the excessive demand for the riskier stocks, which boost the prices more than their fair value. Hence, at the end, expected returns of low-beta stocks outperform.
- Small cap: Over the whole century of the American Bourse existence, the stocks of the small-cap firms have outperformed their large-cap counterparts by an average of 2.7% annually. Why so? Well, these are considered to be more growth opportunities that lead to expected future price appreciations. However, this comes at the costs of great risk. Another most widely acknowledged reasons for anomalies of the small-cap firms’ were scarce trade volumes, frequent acquisitions and a lack of sufficient attention from analysts.
- Momentum: This anomaly means that a certain stock continues to reap abnormal returns beyond the projected levels. Most likely this happens due to the occurence of behavioral biases, where an individual buys additional stocks of already owned shares, therefore boosting their price further. The momentum effect is usually best detected in the 12-month period.
- Reversals: Apart from momentums, there are reversals, which mean the stock performance that is the opposite of the trend before. Hence, today’s outperforms can be next market losers tomorrow. The reason is quite simple: when the stock becomes extremely expensive, no one will want to buy it. If you want to play on reversals, they are typically seen in short-term (one-month) and long-term (five-year) periods.
- Volume: There is a common misperception that a stock experiencing high turnover means it is “healthy”. In fact, empirical research suggests that low-volume stocks are underestimated gems that will reap outstanding returns when they attenuate the interest of institutional investors.
- Volume: There is a common misperception that a stock experiencing high turnover means it is “healthy”. In fact, empirical research suggests that low-volume stocks are underestimated gems that will reap outstanding returns when they attenuate the interest of institutional investors.
This isn’t the most complete list of anomalies detected by researchers and analysts. And yet many of them are not explored. The empirical research shows that trading on anomalies can be risky - many of them are already acknowledged by the public and embedded into the market prices. However, despite being explored by investors, the interesting thing is that these anomalies still persist or continue to occur after some time. And this is where smart market players could exploit them in a meaningful and profitable manner.
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