Chapter 2 - How Investors Make Money

7 stock market anomalies

1) Small firm effect, 2) January effect, 3) Low book value effect, 4) Neglected stock effect, 5) Reversal effect, 6) Days of the week effect, and 7) Dogs of the dow effect.

Dogs of the dow effect

A stock market anomaly where investors could beat the market by selecting stocks in the Dow Jones Industrial Average that had certain value attributes. Investors practiced different versions of the approach, but the two most common were: 1) select the 10 highest-yielding Dow stocks; or 2) go a step further and take the five stocks from that list with the lowest absolute stock price and hold them for a year.

Small firm effect

A stock market anomaly where small firms (re: capitalization) tend to outperform large companies b/c of ability to grow faster at lower costs

Neglected stocks effect

A stock market anomaly where so-called neglected stocks are also thought to outperform the broad market averages. The neglected-firm effect occurs on stocks that are less liquid (lower trading volume) and tend to have minimal analyst support. The idea here is that as these companies are "discovered" by investors, the stocks will outperform.

Reversal effect

A stock market anomaly where stocks at either end of the performance spectrum, over periods of time (generally a year), do tend to reverse course in the following period - yesterday's top performers become tomorrow's underperformers, and vice versa. The anomaly makes sense according to investment fundamentals. If a stock is a top performer in the market, odds are that its performance has made it expensive; likewise, the reverse is true for underperformers. It would seem like common sense, then, to expect that the over-priced stocks would underperform (bringing their valuation back in line) while the under-priced stocks outperform. Reversals also likely work in part because people expect them to work. If enough investors habitually sell last year's winners and buy last year's losers, that will help move the stocks in exactly the expected directions, making it something of a self-fulfilling anomaly.

Days of the week effect

A stock market anomaly where stocks tend to move more on Fridays than Mondays, and that there is a bias toward positive market performance on Fridays. It is not a huge discrepancy, but it is a persistent one.

January effect

A stock market anomaly where stocks that underperformed in the fourth quarter of the prior year tend to outperform the markets in January. Investors will often look to drop underperforming stocks late in the year so that they can use their losses to offset capital gains taxes (or to take the small deduction that the IRS allows if there is a net capital loss for the year).

Low book value effect

A stock market anomaly where stocks with below-average price-to-book ratios tend to outperform the market. Although this anomaly makes sense to a point (unusually cheap stocks should attract buyers' attention and revert to the mean), this is unfortunately a relatively weak anomaly. Though it is true that low price-to-book stocks outperform as a group, individual performance is idiosyncratic, and it takes very large portfolios of low price-to-book stocks to see the benefits.

Efficient Market Hypothesis (EMH)

An economic theory that suggests that market prices fully incorporate information that is known now and that new information is incorporated very quickly into market prices.

Material information

Highly desirable and profitable information that affects the market price of an asset when it's revealed to the market.

Private information

Information that is known only to a few people and isn't widely distributed or shared.

Proponents of EMH

These are people who think the market is EFFICIENT. If you think markets are very efficient, then you can simply be a passive investor. When you invest, you should aim to buy your own slice of the entire market and ear whatever return the market delivers.

Opponents of EMH

These are people who think the market is INEFFICIENT and believe they can earn a higher return that the market. If you want to try to beat the markets, you have to put in the time and effort it takes to learn about companies and decide whether their market prices are right.

RESOURCES

https://www.economist.com/news/finance-and-economics/21722669-theory-changing-traders-behaviour-and-vice-versa-efficient-market-theory https://www.investopedia.com/articles/financial-theory/11/trading-with-market-anomalies.asp