Why Market Anomalies Exist And How To Profit From Them

Market anomalies rely heavily on history repeating itself which is not based on fact as historical analysis is known to have offered little advantage to investors

If there’s anything we can get from how market anomalies work, it is that they can be exploited to make short term gains, but they can also not just work out. They are called anomalies because they either should not occur at all, or because just like everything in the stock market, they should, at least, not be predictable.

So why then do they happen? How did the first anomaly start and how did it reveal patterns?

Most of what we can learn about how they work is tied to how we behave as humans – this is behavioral finance.

Behavioral finance is the study of how psychology affects the behavior of investors or other market participants by trying to create a rational reason for the irrational behavior of these market participants.

It, thus, uses psychology-based theories to explain stock market anomalies. It opposes to a lot of what we know as conventional like the Efficient Market Hypothesis (EMH), principally because it tries to predict behaviors. There are several concepts used in behavioral finance including:

Conservatism

Conservatism assumes that market participants are conservative and would rather stick to their old beliefs than trying to adopt new information or new strategies regardless of the gains attached to it.

Familiarity Bias

Familiarity bias is that market participants focus on areas that they understand. It could be from investing primarily in their country of residence, companies they know, and so on. \

This might be part of investing in the companies they work for or are very familiar with. And because of the concentration, risk might be increased as there would be very little or no form or portfolio diversification.

Overconfidence

This is simply just it. Market participants are too confident about the stocks they invest in. They overestimate their knowledge, their available information, and so on. The irony of this is that this kind of overconfidence can lead to irrational behavior.

Making Profit From Market Anomalies

The first thing to note is that market anomalies can only be gained from when you focus on short term trading as opposed to long term investment. And that has its multiple challenges on its own.

Also, market anomalies rely heavily on history repeating itself which is not based on fact as historical analysis is known to have offered little advantage to investors.

Because profits earned from market anomalies are minimal, they could be eliminated with the costs that come with continuous trading and even lead to losses.

While it is important to understand how market anomalies work, especially so you are not caught unawares, it is also better to use these anomalies simply to aid your decision making process and not to strive to profit from them consistently.

Written by Lawretta Egba.