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Thursday, 5 November 2009

Pricing Anomalies: Now You See Me, Now You Don’t

Imaginary Beasties

Down the years researchers have identified a whole host of pricing anomalies that offer strategies to outperform markets. Unfortunately as soon as anyone starts to exploit them these little beasts disappear like a bunny in a magician’s hat, leading everyone to wonder whether they ever existed at all.

The use of backtesting to identify such models which are then presented to the world as methods for getting rich – or at least ways of avoiding getting poor – shows, quite clearly, that the anomalies did exist at some point. So it appears we have the financial equivalent of the conjuror’s trick: now you see me, now you don’t.

Bad Models or ...

There are two reasonable explanations of what might be going on. The first, roughly, is that the pricing anomaly really never existed in the first place and was the figment of fevered financial researchers’ imaginations. The second, even more roughly, is that as soon as the effect is identified then the market moves to eliminate the inefficiency: which is, after all, what you’d expect of an even vaguely efficient market.

The possibility that some of these effects never existed at all is a serious one. To identify the anomaly in the first place you have to have something to baseline it against. Given that all of the models of markets we’ve seen so far are seriously deficient at the extremes (see The Death of homo economicus, Holes in Black Scholes, etc, etc) there’s every reason to wonder if these apparent pricing inefficiencies are simply errors resulting from the modelling. After all, most market models are built around assumptions of efficiency and even if these are only roughly right the existence of clear inefficiencies would be odd.

Of course, given that all anomalies are identified through backtesting the possibility is open that the effect was simply a statistical blip. Take other data sets from other eras or other markets or an alternative universe and it may disappear. This is almost certainly what’s happening some of the time – but not all of it.

Loose Market Efficiency?

Still, if the pricing anomaly exists but hasn’t been recognised then there’s no especial reason for the markets to arbitrage it away. The fact that the effects disappear after they become widely known would suggest that markets are loosely efficient – they don’t necessarily act of their own accord to remove inconsistencies but will, if pushed and prodded towards the problem, do the right thing like a child eating its vegetables under duress and the promise of a highly calorific dessert, a new bike and the latest computer console. Slowly and painfully.

If you follow this logic through, even roughly, it would suggest that any pricing anomaly which becomes well known will disappear – even ones that are clearly based on human behavioural weaknesses. After all, in an age where mass computing power is available to the financial institutions that dominate our markets and Harry Potter lookalikes with whizzy computer models can swiftly magic up a program to exploit any identifiable discrepancy we should be moving towards greater market efficiency.

Instead of which, of course, we’re not. Which is good because otherwise I’d have nothing to write about.

And the Losers are ...

As G. William Schwert points out, amongst the effects which were once bang-on winners but are now vanishingly irrelevant are the size effect, the value effect, the weekend effect and the dividend yield effect. The latter’s particularly interesting since an investment strategy based on predicting stock returns from historical dividend yield data was pretty successful up until the 1990’s when it failed spectacularly. Historically robust models can do you extreme damage if you trust in them too much: can anyone remember when bonds had never yielded more than equities? Nah, you’re all too young.

The value effect, where companies with low P/E ratios compared to the market earn excess returns, was identified back in the early 1980’s. Similar ‘value’ effects accruing to companies with high dividend yields or with assets in excess of their market capitalisations were also identified. However, when French and Fama modified the Capital Asset Pricing Model (CAPM) to take account of risk associated with company size and discounts to net asset value they discovered that the anomaly vanished.

Brilliantly the French and Fama three factor model rests not on the exploitation of reliable underlying market inefficiencies but on the fact that most of the market participants insist on using models that are demonstrably wrong. Here lies a delicious irony – it’s the activities of the boy wizards and their efficient market models that create the inefficiencies that allow others to make excess returns. They’re probably too busy fiddling with their broomsticks to take notice.

Heroic Smaller Investors

It really isn’t very hard to see why anomalies disappear once people start looking at them closely. What’s more interesting is why some anomalies don’t go all shy and retiring. The momentum effect, where stocks that have done well continue to do so and stocks that are lousy dogs keep on barking appears to be robust over all timescales and isn’t explicable by any modification of the current models. It’s also a possible explanation for the heroic underperformance of behaviourally challenged small investors who are apt to sell winners, which keep on winning, and keep losers, which keep on losing, in an attempt to continue to fund the securities industries’ enormous costs.

This underperformance is itself an anomaly, although one it’s difficult to exploit. Outside of the fat tails of market manic-depression one would generally expect even private investors to at least achieve market average returns. After all, efficient markets work both ways – it may be difficult to outperform but it should equally be hard to underperform. For their truly legendary efforts to disprove the Efficient Market Hypothesis smaller investors should be applauded, even if we simultaneously have serious doubts about their sanity.

An Exploitable Anomaly

It’s not just private investors that demonstrate such market beating, in a negative sense, abilities. Fund managers should, all things being equal, underperform the market to the extent of their fees. By and large this is true, low cost index funds included, but there are a few outstanding active managers who demonstrate the “cold hands effect” and produce underperformance of a magnitude that simply isn’t explicable by chance. As Hendricks, Patel and Zeckhauser put it:
"The relative performance of no-load, growth-oriented mutual funds persists in the near term, with the strongest evidence for a one-year evaluation horizon. Portfolios of recent poor performers do significantly worse than standard benchmarks; those of recent top performers do better, though not significantly so."
So there you have it, finally: a truly exploitable anomaly. Find the very worst performing fund managers and do the exact opposite. Otherwise work hard on your real job, invest regularly in index trackers across a number of asset classes and expect to make no more than 8% per annum on a compounded basis. If you do the sums and don’t like the outcome then work harder and invest more, don’t count on higher investment returns – especially if your alternative is to bet on a backtested anomaly. After all, you never know when the darned thing will disappear in a puff of smoke.

Related Articles: Investing With A Time Machine, The Case Of The Delusional Investor, Real Fortune Telling: Dividend Forecast Indexing


  1. There has never been a single study showing that the market is efficient in the short term, Tim. You talk as if you know of such a study. You talk as if this claim (which has been made millions of times) had been proven. But I know that there is no such study because I have spoken with thousands of people who believe in the idea of immediate efficiency and not one has ever been able to point me to one.

    The idea that the market is immediately efficient is a mistake. It is the biggest mistake ever made in the history of personal finance. It has caused more human misery than any other mistake ever made in the history of personal finance.

    When I ask believers for studies showing that the market is efficient in the short term, I get hundreds of studies showing that short-term timing doesn't work. I am persuaded that those studies tell us something important. But I am also persuaded that they do not tell us what the believers think they tell us.

    There are two possible explanations for a finding that short-term timing doesn't work. One is that the market is immediately efficient. That's the one that Fama & Company went with. That's the one that has caused today's economic crisis.

    The other perfectly logical explanation is that market prices are determined by emotion in the short term and that efficiency kicks in only over time (sometimes taking as long as 10 years). If that is the true explanation, long-term timing is essential. If that is the true explanation, a model for understanding how stock investing works that tells people not to time the market is ultimately going to cause the biggest crash ever seen in history. So we had better make sure that explanation is false before we dismiss it.

    There has never been one sliver of evidence put forward that that explanation does not hold up. The entire historical record shows that valuations have always had a huge effect on long-term returns, a reality that makes zero sense if the market is immediately efficient and that makes perfect sense if prices are set by emotion in the short term and if the market becomes efficient only over time.

    I believe that prices are set almost entirely by emotion in the short term and that the market becomes efficient only over time. Because that's what my common sense tells me. And because the entire historical record supports that understanding of things. And because the many "experts" who have been telling us for years now that the market is immediately efficient have not been able to point to a single rational explanation for why they believe in immediate efficiency rather than gradual efficiency. And because every time large numbers of people have come to believe that there is no need to change one's stock allocation in response to big price changes they have experienced a wipeout of the accumulated wealth of a lifetime and the entire economy has experienced a breakdown.

    There are some ideas that are potentially so dangerous that they should not be advanced unless those putting them forward are very, very, very sure. Given that there has never been a time in the entire historical record in which the idea that the market is gradually efficient did not work well for those following it, I question how those who believe in immediate efficiency can be so confident of their claims. My take is that they are not confident but defensive. The two things can appear similar for a time but are rooted in very, very different realities.

    When I see one study showing that long-term timing doesn't always work, I will change my mind. Until then, I will continue to go with what common sense tells me must be so. I implore those who today believe in immediate efficiency to open their minds to other possibilities. The price of getting this one wrong could be huge indeed. The stakes here are as high as they could possibly be.


  2. whether the market is acting efficiently or not is difficult to prove, but i believe it sometimes is and sometimes isn't. for example along with all the matter in space there is also anti matter, and depending on where you are in the continuom that is what you'll experience. so with relation to the markets if it's efficient for 10mins at 09:00 and you find a clear pattern that fits your system then you will be successful, however if you enter the same trade at a time when the market is inefficient it could go against you. Realising when the market is behaving efficiently is the key to consistent success. why should anyone be against people trying to time the market? have you played roullete, don't you know that it's better to place your bet after the dealer has released the ball, is that not timing? is it done by everyone?