7 Market Anomalies Investors Should Know

It is generally a given that there are no free rides or free lunches
on Wall Street. With hundreds of investors constantly on the hunt for
even a fraction of a percent of extra performance, there should be no
easy ways to beat the market. Nevertheless, there are certain tradable
anomalies that seem to persist in the stock market, and those
understandably tend to fascinate many investors.

While these anomalies are worth exploration, investors should keep
this warning in mind – anomalies can appear, disappear, and
re-appear with almost no warning. Consequently, mechanically following
any sort of trading strategy can be very risky.

*TUTORIAL: Detecting Market Strength*
*Small Firms Outperform*The first stock market anomaly is that smaller
firms (that is, smaller capitalization) tend to outperform larger
companies. As anomalies go, the small firm effect makes rather a lot
of sense. A company's economic growth is ultimately the driving force
behind the performance of its stock and smaller companies have much
longer runways for growth than larger companies. A company like
*Microsoft* (NYSE:MSFT) might need to find an extra $6 billion in
sales to grow 10%, while a smaller company might needs only an extra
$70 million in sales for the same growth rate. Accordingly, smaller
firms typically are able to grow much faster than larger companies and
the stocks reflect this.

*January Effect*The January Effect is a rather well-known anomaly.
Here, the idea is that stocks that underperformed in the fourth
quarter of the prior year tend to outperform the markets in the month
of January. The reason for the January Effect is so logical that it is
almost hard to call it an anomaly. Investors will often look to
jettison underperforming stocks late in the year if they have a loss
in them so that they can use those 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).

As this selling pressure is sometimes independent of the actual
fundamentals or valuation of the company, this "tax selling" can push
these stocks to levels where the stocks become attractive to buyers in
January. Likewise, investors will often avoid buying underperforming
stocks in the fourth quarter and wait until January, so as to avoid
getting caught up in this tax-loss selling. As a result, there is
excess selling pressure before January and excess buying pressure
after January 1, leading to this effect.

*Low Book Value*Extensive academic research has shown that stocks with
below-average price-to-book ratios tend to outperform the market.
Numerous test portfolios have shown that buying a collection of stocks
with low price/book ratios will deliver market-beating performance.
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, the individual performance
is very idiosyncratic and it takes very large portfolios of low
price-to-book stocks to see the benefits.

*Neglected Stocks*A close cousin of the "small firm anomaly",
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.

Research suggests that this anomaly actually is not true – once the
effects of the difference in market capitalization are removed, there
is no real outperformance. Consequently, companies that are neglected
_and_ small tend to outperform (because they are small), but larger
neglected stocks do not appear to perform any better than would
otherwise be expected. With that said, there is one slight benefit to
this anomaly – though the performance appears to be correlated with
size, neglected stocks do appear to have lower volatility.

*Reversals*There is some evidence that 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.
Not only is there statistical evidence to back this up, the anomaly
also makes some sense according to investment fundamentals. If a stock
is a top performer in the market, the odds are that the stock's
performance has made it expensive; likewise in reverse for the
under-performers. It would seem like common sense, then, to expect
that the over-priced stocks then underperform (bringing their
valuation back more 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 to move the stocks in exactly the
expected directions, making it something of a self-fulfilling anomaly.

*Days of the Week*Efficient market supporters hate the Days of the
Week anomaly because it not only appears to be true, but it makes no
sense. Research has shown that stocks tend to move more on Fridays
than Mondays and that there is a bias towards positive market
performance on Fridays. It is not a huge discrepancy, but it is a
persistent one.

On a fundamental level, there is no particular reason that this should
be true. Some psychological factors could be at work here, though.
Perhaps there is an end-of-week optimism that permeates the market as
traders and investors look forward to the weekend. Alternatively,
perhaps the weekend gives investors a chance to catch up on their
reading, stew and fret about the market, and develop pessimism going
into Monday.

*Dogs of the Dow*The Dogs of the Dow is included as an example of the
dangers of trading anomalies. The idea behind this theory was
basically that investors could beat the market by selecting stocks in
the Dow Jones Industrial Average that had certain value attributes.
There were different versions of the approach, but the two most common
were to select the 10 highest-yielding Dow stocks or go a step further
and take the five stocks from that list that had the lowest absolute
stock price and hold them for a year.

It is unclear whether there was ever any basis in fact for this
approach, as some have suggested that it was a product of data mining.
Even if it had once worked, the effect would have been arbitraged away
- say, for instance, by those picking a day or week ahead of the first
of the year. Moreover, to some extent this is simply a modified
version of the reversal anomaly; the Dow stocks with the highest
yields probably were relative underperformers and would be expected to

*Conclusions*Attempting to trade anomalies is a risky way to invest.
Not only are many anomalies not even real in the first place, they are
very unpredictable. What's more, they are often a product of
large-scale data analysis that looks at portfolios made up of hundreds
of stocks that deliver just a fractional performance advantage. Since
these analyses often exclude real-world effects like commissions,
taxes and bid-ask spreads, the supposed benefits often disappear in
the hands of real-world individual investors.

With that said, they can still be useful, to a certain extent. It
seems unwise to actively trade against the Day of the Week effect, for
instance, and investors are probably better off trying to do more
selling on Friday and more buying on Monday. Likewise, it would seem
to make sense to try to sell losing investments before tax-loss
selling really picks up and to hold off buying underperformers until
at least well into December.
All in all, though, it is probably no coincidence that many of the
anomalies that seem to work hearken back to basic principles of
investing. Small companies do better because they grow faster, and
undervalued companies tend to outperform because investors scour the
markets for them and push the stocks back up to more reasonable
levels. Ultimately, then, there is nothing really anomalous about that
at all – the notion of buying good companies at below-market
valuations is a tried and true investment philosophy that has held up
for generations.

*by Stephen Simpson*,CFA
Stephen Simpson, CFA, is a freelance financial writer, investor, and
consultant. He has worked as an equity analyst for both sell-side and
buy-side investment companies in both equities and fixed income.
Stephen's consulting work has focused primarily upon the healthcare
sector, while he has also written extensively for publication on
topics pertaining to investments, security analysis, and healthcare.
Simpson operates the Kratisto Investing blog, and can be reached
Source: Investopedia.Com