Author: Dr Penny Pincher / Source: Wise Bread
It is often said that it’s impossible to “beat the market.” There’s no magic formula for success. If everyone is trading based on the same information, stocks should always sell for a fair price. At least, that’s the idea if markets are what economists call “efficient,” meaning all relevant information is available to all parties at the same time and that prices respond immediately to that information.
But sometimes the stock market doesn’t behave that way. Stock prices may not actually reflect the underlying asset valuation of the company. This phenomenon is known as a stock market anomaly.
Think of anomalies as quirky rules of thumb that don’t always hold. For instance, stock prices have been known to rise in the period after Christmas in what’s called the Santa Claus rally. Some investors try to take advantage of these trends to pick up extra profit, but of course, the Santa Claus rally doesn’t happen every year, so there’s risk involved. The same goes for the other types of anomalies.
As we’ve heard before, past performance is no indication of future success. Likewise, there’s no guarantee that anomalies will repeat themselves.
Nevertheless, it’s worth informing yourself about market anomalies so you can decide for yourself whether you want to try to take advantage of them. Here are some of the most common stock market anomalies. (See also: Does Skill Really Matter in Stock Market Investing?)
1. Reversal anomaly
What goes down must eventually come up — and vice versa. This anomaly states that stocks that are performing very well tend to reverse course the following period and decrease in value.
Stocks that are performing poorly follow a similar course — they tend to increase in value the following period.There are a couple of logical explanations for this behavior. Perhaps investors anticipate that high performing stocks won’t perform at that level indefinitely, and start to price in the expectation that they will come down.
From a statistical perspective, this anomaly could be an example of regression to the mean, meaning you’ll get a more representative average price by examining the data over a longer interval than by looking at the price over a shorter interval in which performance happens to be above or below average.
2. Dogs of the Dow
The Dogs of the Dow theory states that by picking the right subset of stocks in the Dow Jones industrial average, you can beat the market. Investors who try this approach do so by picking the 10 Dow stocks with the highest dividend-to-price ratio. A further refinement is to take the five stocks on that list of 10 that have the lowest stock price, and hold them for a year.
Whether the Dogs of the Dow is a consistent phenomenon or not is debatable, but picking underperformers may be an extension of the reversal anomaly; stocks that are performing relatively poorly tend to improve eventually.
3. January effect
The January effect is when stocks that underperformed from October through December suddenly perform better than average come January. A possible explanation for this anomaly is that investors are motivated to sell underperforming stocks at the end of the year to claim a loss to lower capital gains taxes. Once they’re done selling, the price rebounds.
This is a case where stock price can be affected by factors other than their expected return and risk….
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