Question

The size effect, value effect and day of the week effect represent three empirical challenges to market efficiency hypothesis. Drawing from empirical research evidence, explain how these anomalies challenge the market efficiency hypothesis.

Answer 1

ANOMALIES OF MARKET EFFICIENCY HYPOTHESIS

Anomalies are empirical results that seem to be inconsistent with maintained theories of asset-pricing behavior. it refers to situations when security or group of securities perform contrary to the notion of efficient markets, where security prices are said to reflect all available information at any point in time.

Market efficiency refers to the degree to which market prices reflect all available, relevant information. The efficient market hypothesis states that an investor cant outperforms the market and those market anomalies should not exist because they will immediately be arbitraged away. A truly efficient market eliminates the possibility of beating the market because any information available to any trader is already incorporated into the market price. There are three degrees of market efficiency. the weak form, semi-strong form, and the strong form.

According to the Efficient Market hypothesis, stock always trades at their fair value on an exchange, making it impossible for investors to purchase undervalued stocks or sell stocks for an inflated price. therefore it should be impossible to outperform the overall market through expert stock selection or market timing and the only way an investor can obtain higher return is purchasing riskier investments.

size effect anomaly

The size effect is a market anomaly in asset pricing according to the market efficiency theory. The size effect is one of these significant anomalies, which has been discovered by empirical tests of the CAPM (Berk 1995). Banz (1981) describes a negative relationship of size to returns, in other words, he discovered that returns of small firms are significantly larger than the returns of larger firms. small companies(that is one with smaller market capitalization) tend to outperform larger firms.

Let’s imagine a big company that needs over 1 crore to achieve a 10% growth rate, while a smaller company needs only 10 lakh extra sales for obtaining the same growth rate. Therefore, smaller companies are able to grow faster than larger companies, and that is reflected in their stocks.

The day of the week effect anomaly

The efficient market hypothesis supporters hate the days of the week anomaly because it not only appears to be true but it also make no sense. The day of the week effect is one of the regularities observed in financial markets which suggests that Friday returns are higher than Monday returns. One of the possible reasons for this regularity is that the date of trade in equity markets is not always the same as the date that payment is made or the settlement date. The number of days that investors have to wait for payment is higher when that trade is realized on Fridays rather than on Mondays (due to the weekend holidays). Thus, investors have a few more days to use the money in alternative markets when the trade has been realized on Fridays and until the trade is settled on the settlement date. This paper provides empirical evidence that as the return in alternative markets (overnight interest rates) decreases, the day of the week effect decreases. Thus, there should be a positive relationship between the expected relative returns from Friday to Monday and overnight interest rates.

Value effect anomaly

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, individual performance is idiosyncratic, and it takes very large portfolios of low price-to-book stocks to see the benefits.