Investment Anomalies and return predictability Flashcards
What are ‘reversals’?
This is a strategy where investors take advantage of the fact that ‘losers become winners’ and ‘winners become losers’ in the long term (typically 3-5 years)
What is ‘momentum strategy’?
1) Rank stocks on their returns for the past 3-12 months
2) Form a hedge portfolio of winners and loser for zero investment
3) Hold the hedge portfolio for 3-12 months
4) Earn abnormal returns
What possible explanations are there for momentum?
1) The market fails to incorporate information in prices quickly enough. The adjustment is gradual so prices drift.
2) Prior returns may have incorporated other information that is not related to returns and so again it takes time for prices to adjust
What is the earnings announcement puzzle and why does it violate the EMH?
The earnings announcement puzzle is that firms announce earnings and their abnormal returns drift for a period of time afterwards. This is an example of under/overreaction. this violates the EMH because prices should reflect new information quickly.
What is the Twin Stocks Puzzle?
Royal Dutch and Shell merged. Royal Dutch got 60% while Shell got 40%. Royal Dutch’s stock price should have been 3/2 times the prices of Shell’s due to arbitrage pricing but this was not the case. This is a violation of the EMH.
What is a bubble?
This is where the price of an asset rises above its intrinsic value. An example of this is the Dot Com Bubble of the late 90s.
What are some calendar anomalies?
January effect - Most of the premium for small cap and high B/M portfolios comes in January
Monday effect - Returns on Monday are lower than the rest of the week
Turn of the Month effect - Stocks show higher returns on the last and first day of the month
What is behavioral finance?
Identifying scenarios in which markets are not perfectly efficient and providing explanations for why the market may not be efficient.
Name some psychological biases?
1) Conservatism
2) Representativeness
3) Over-confidence
What is conservatism psychological bias
Individuals are slow to change their beliefs in the face of new evidence. Conservatism implies underweighting of new evidence.
What is representativeness psychological bias
People give too much weight to recent patterns in the data and too little to the properties of the population
