Exploit Three Main Anomalies in the Efficient Market Hypothesis

Billy Williams

Earning above-market returns without taking on more risk than the market is nearly impossible, according to the Efficient Market Hypothesis (EMH).

Therefore, buying and holding low-cost index market funds appears to be the only winning investment strategy. However, some investors outperform the market consistently enough to explore whether any EMH anomalies can be exploited to beat the market.

While data from mutual-fund returns seems to support a weak form of the EMH, several well-known anomalies, or deviations from the expected behavior, complicate the picture.

Three generally accepted “anomalies” of EMH are (1) the size effect, (2) the valuation effect and (3) the momentum effect.

  1. Research on the size effect shows that companies with smaller market capitalizations have historically outperformed those with large market capitalizations, even after controlling for their higher risk. Research conducted by Eugene Fama and Kenneth French shows that stocks with market capitalizations in the smallest 30% of companies in the data set outperformed those with market caps in the largest 30% by an average of 4.5% a year since 1926, when the data set begins. Small stocks had an average annualized return of 15.4% vs. 10.8% for large stocks during that time. While quite impressive, this outperformance was volatile, as the chart below shows that there were many five-year periods when large stocks actually outperformed small stocks. In fact, while small stocks outperformed impressively overall, they did so in only 49% of all individual months.

graf

  1. Research on the valuation effect shows that companies with low price/book (P/B) multiples have historically outperformed those with higher P/B multiples. Again using research from Kenneth French’s Dartmouth website, a portfolio that bought the lowest 30% of stocks by the P/B ratio every year and held them for a year would have returned an average of nearly 18% a year, versus only 12% for an equally weighted portfolio of stocks with an average multiple. This is quite significant outperformance. Again, this outperformance did not persist over every time period.
  2. Research on the momentum effect shows that companies that have performed the best over the past six months to one year tend to perform better than the set of companies that have performed the worst over a similar period.
Exclusive  Obama's Crimea Comments Lead to Lower Stocks

Of course, the EMH implies that as soon as an anomaly becomes popularized, it will likely cease to exist. Imagine that stocks always went up on Fridays and down on Mondays. If this anomaly became widely known, many would try to buy stocks on Thursday afternoon right before the close and sell them at a similar time on Friday afternoon to capture this Friday bounce. But if everyone tried to buy shares on Thursday afternoon and sell on Friday afternoon, by simple supply and demand, prices would have to go up on Thursday and down on Friday. The Friday boom would turn into a Friday bust.

Investors who try to take advantage of any proclaimed anomaly must be very aware of the potential for this dynamic to show up again and again. As soon as it appears that “easy money” is on the table, thousands of aggressive, return-seeking fund managers will immediately try to grab it.

Implications for Individual Investors

While the degree to which stock prices are efficient remains a subject of debate, the evidence from investor returns shows that for the majority of individual investors, they might as well be. Market efficiency has some sobering lessons for aspiring stock-pickers who remain unconvinced of its full validity:

  • If something seems like “easy money,” pause. Remember that thousands of other professional investors have observed the same facts as you and decided to pass. Ask yourself what you could be missing.
  • Always approach an investment by first understanding why the stock is trading like it is. Only then consider whether you think the market is right or wrong. For instance, do not buy a stock that is selling at a discount to its industry on a number of metrics just because it looks cheap. First, understand why that stock may be cheap, then develop your own view on whether the valuation is justified or not.
  • Remember that there is always someone else “on the other side of the trade.” Could this person be more informed than you or know something you do not? What do you know or realize that the person selling the stock to you is missing?
Exclusive  August Jobs Report Falls Short of Rate Hike Level

Therefore, the three main EMH “anomalies” — the size effect, the valuation effect and the momentum effect — must be used in conjunction other market analysis concepts and tools to determine whether a particular stock is a “buy”. A factor to consider is –the time value of money, which will be covered in a separate article.

Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader,” and to learn more about profitable trading, go to www.stockoptionsystem.com.

Like This Article?
Now Get Mark's FREE Special Report:
3 Dividend Plays with Sky-High Returns

This newly-released report by a top-20 living economist details three investments that are your best bets for income and appreciation for the rest of the year and beyond.

Get Access to the Report, 100% FREE


img
previous article

Author and trader Billy Williams discusses how valuable the Efficient Market Hypothesis is for investors and what lessons we can take from it.

PREMIUM SERVICES FOR INVESTORS

Dr. Mark Skousen

Named one of the "Top 20 Living Economists," Dr. Skousen is a professional economist, investment expert, university professor, and author of more than 25 books.

Product Details

LEARN MORE HERE

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

Product Details

LEARN MORE HERE

Jim Woods

Jim Woods has over 20 years of experience in the markets from working as a stockbroker,
financial journalist, and money manager. As well as a book author and regular contributor to
numerous investment websites, Jim is the editor of:

Product Details

LEARN MORE HERE

Bob Carlson

Bob Carlson provides independent, objective research covering all the financial issues of retirement and retirement planning. In addition, Bob serves as Chairman of the Board of Trustees of the Fairfax County (VA) Employees’ Retirement System, which has over $2.8 billion in assets.

Product Details

LEARN MORE HERE

Mike Turner

Mike Turner’s financial, mathematical, computer science and engineering background serves as the foundation for his disciplined, rules-based approach to trading. Mike’s three services include:

Product Details

LEARN MORE HERE

Hilary Kramer

Hilary Kramer is an investment analyst and portfolio manager with 30 years of experience on Wall Street. Since 2010, Hilary's financial publications have provided stock analysis and investment advice to her subscribers:

Product Details

LEARN MORE HERE

DividendInvestor.com

Used by financial advisors and individual investors all over the world, DividendInvestor.com is the premier provider and one-stop shop for dividend information and research.

Product Details

Popular tools include our proprietary Dividend Calendar, Dividend Calculator, Dividend Score Card, and many more.

LEARN MORE HERE