MARKET
OUTCOMES
JENNY ROSE C. AYSON
CHAPTER 13
BEHAVIORAL EXPLANATION FOR
ANOMALIES
1) the small-firm effect
2) lagged reactions to
THESE KEY
earnings
ANOMALIES announcement;
REVIEWED 3) value versus growth;
WERE: 4) momentum and
reversal.
THE SMALL-FIRM EFFECT
• The small-firm effect is not usually attributed
to behavioral factors. Yet, it is included in
the group of key anomalies because it plays
a central role in the Fama-French three-
factor model, which has become a
conventional risk-adjustment technique.
13.2 EARNINGS
ANNOUNCEMENTS
AND VALUE VS.
GROWTH
W H AT I S B E H I N D L A G G E D
REACTIONS TO EARNINGS
ANNOUNCEMENTS?
• Recall that extreme earnings announcements,
whether very positive or very negative, are only
incompletely reflected in prices, leading to a
period of delayed traction. What may partly
explain this evidence of post-announcement
drift is that it seems that both analysts and
investors anchor on recent earnings, implying
that they underreact to new information.
W H AT I S B E H I N D T H E VA L U E
A D VA N TA G E ?
• The first two reasons are mistakes in judgment, and one
might guess that individual investors more prone to
committing them than are institutional investors;
1. They are committing judgment errors in extrapolating
past growth rates too far into the future, and are thus
surprised when value stocks shine and glamour stocks
disappoint. This is the so-called expectational error
hypothesis.v
2. Because of representativeness, investors may assume
that good companies are good investments.
• The next two reasons are due to agency considerations.
They both suggest that, while institutional investors may
know better, because of career concerns, they may avoid
value stocks;
3. Because sponsors view companies with steady earnings
and buoyant growth as prudent investment, so as appear to
be following their fiduciary obligation to act prudently,
institutional investors may shy away from hard-to-defend
4. Because of career concerns, institutional investors, who
are evaluated over short horizons, may be nervous about
tilting too far in any direction, thus incurring tracking
error. A value strategy would require such a tilt and may
take some time to pay off, so it is in this sense risky.
1 3 . 3 W H AT I S B E H I N D
MOMENTUM AND REVERSAL?
• Recall the existence of intermediate-term
momentum and long-term reversal. Putting
these results together suggests that investors
first underreact and then over- react. In essence
we have a combination of the underreaction
seen in the earnings. announcement literature
and the overreaction requiring reversal that we
see in the value literature.
DANIEL-HIRSHLEIFER-
S U B R A H M A N YA M M O D E L A N D
EXPLAINING REVERSAL
The Daniel-Hirshleifer-Subrahmanyam model
(hereafter DHS) is based on overconfident
investors overestimating the precision of their
own private signals. This leads to negative
serial correlation in prices, or reversal.
G R I N B L AT T- H A N M O D E L A N D
EXPLAINING MOMENTUM
• As stated before, the Grinblatt-Han model
(hereafter GH), is based on prospect theory, mental
accounting, and the disposition effect. In brief, the
tendency for winners/losers to be sold two
quickly/slowly suggests a delayed reaction to good!
bad news, because reference-point influenced
investors have demand curves that reflect recent
performance.
B A R B E R I S S H L E I F E R -V I S H N Y
MODEL AND EXPLAINING
MOMENTUM AND REVERSAL
• The Barberis-Shleifer-Vishny model (hereafter
BSV) is driven by the tendency for individuals to
be coarsely calibrated in the sense of this
example, that is, to either believe that things are
black or white. Their model leads to a world
where investors at first underreact, and then
overreact to salient news. Or, one can say that
investors "overreact slowly"
R AT I O N A L E X P L A N AT I O N S
• One should not immediately declare that
markets are inefficient because anomalies
have been detected. There are, in fact, a
number of explanations that are perfectly
consistent with rationality and efficiency.
I N A P P R O P R I AT E R I S K
ADJUSTMENT
As mentioned earlier, all tests of efficiency are
by their very nature joint hypothesis tests.
FA M A - F R E N C H T H R E E - FA C T O R
MODEL
• According to the Fama-French three-factor
model, excess returns are calculated not just
after accounting for market risk, but also
after adjusting for risk factors associated
with size and book-to-market.
EXPLAINING MOMENTUM
• The Fama-French three-factor model is not
able to account for momentums, a point that
even Fama and French concede. But other
risk-based explanations for momentum have
been proposed. For example, some research
relates momentum to the business cycle and
the state of the market, arguing that (non-
diversifiable) macroeconomic instruments
account for a large portion of momentum
T E M P O R A R Y D E V I AT I O N S F R O M
EFFICIENCY AND THE ADAPTIVE
MARKETS HYPOTHESIS
• It is possible that markets are sometimes temporarily
inefficient, but when a sufficient number of arbitrageurs figure
out how to capitalize on an inefficiency, mispricing gradually
disappears.
• The rise and fall (followed by recurrences) of anomalies in
consistent with the adaptive markets hypothesis of Andrew Lo,
who has recently suggested that this cyclicality is to be
expected in a world where markets are subject to evolutionary
forces.
