Perspectives on Capital Market Anomalies

Abstract

This book describes unexpected price behavior in equity markets, termed “anomalies,” that can potentially be exploited by investors to earn abnormal returns. An anomaly in capital markets is a deviation from the prediction of the efficient markets theory. The purpose of this chapter is to provide a conceptual framework for understanding the academic research on anomalies, and to help the reader evaluate whether certain anomalies can be profitably exploited. Section 1.1 begins with a discussion of efficient markets theory, which specifies how assets (specifically, stocks) are expected to be priced under a set of ‘ideal’ or theoretical conditions. Sections 1.2 to 1.4 discuss anomalies, or price behavior that is unexpected if markets are efficient. These sections (1.2 to 1.4) define anomalies, discuss explanations for anomalies that have been examined in the academic literature and conclude by weighing the evidence for these different explanations. Since anomalies yield predictable positive risk-adjusted returns, proper risk measurement is critical to the identification of anomalies. Hence, the appendix to this chapter provides a detailed review of risk measurement and expected return models. No specific anomaly is discussed in this chapter, as the discussion here is intended to be applicable to all anomalies. It is hoped that, at the end of this chapter, investors will have the conceptual tools necessary to evaluate and understand observed price behavior in general, and the anomalies discussed in the subsequent chapters in particular.

Keywords: Capital Markets, Anomalies, Investments, Asset Pricing, Financial Accounting

JEL Classification: G10, G12, G14, G30, K22, M40, M41