Question

Can behavioral finance explain anomaly in the market?

Answer 1

In general, anamoly is something that deviates from what is standard, normal or expected. In finance, an anamoly is when the actual result is differenct from expected under certain assumptions.

There are two common types of anamolies - market anamolies and pricing anamolies.Market anamolies results when there is contradiction in results and Pricing anamolies results when stock price is different from predicted price.

Behavioral finance is an area of study that proposes various theories to explain market outcomes and anamolies. Returns from stock market is an area where finance behaviour influence market outcomes and returns. It helps people to make certain financial choices and also helps to understand how these choices affects market.

Below are the most common anamolies that describes how behavioral finance affects market:

Calender effects: It is the group of anamolies that occur at particular times or particular dates throughout a year like weekend effect, holiday effect, month end effect. Weekend effect is the tendency of stock prices to close lower on Mondays than on previous Fridays. Many believes that this effect is mostly caused by the negative news coming on weekends. Same is the case when there are long holiday vacations in market and month end.

Earning announcement: There is much more volatility in a stock prices when earnings are to be announced. Means, there may be rally in prices on pre-earning announcement on assumption that earnings will be good than expected. After earning are announced, there is tendency that there will be correction in prices due to previous huge rally. And if earnings are not as per expectation, then there will be steep fall in prices.

Momentum effects: It is based of technical analysis that suggests that there will be rally in stock price of a certain company that are winners in certain criterias. It suggests that traders can take advantage of these price movements by going long on good stocks and short of bad stocks.

Value effects: It refers to the tendency of stock that are below priced as compared to the book value and as per outcome of balance sheet. If the market value is higher than the book value per share, a stock is considered to be overvalued. And if the book value is higher than the market value, the the stock is considered as undervalued. Considering this, trades can go long and short accordingly.