7 market anomalies every investor should know

There is no free rider or free lunch on Wall Street, which is generally accepted. Hundreds of investors have been looking for even one percent extra performance, and there is no easy way to beat the market. Nevertheless, certain tradable anomalies still seem to exist in the stock market. It is understandable that these anomalies have fascinated many investors.

Although these anomalies are worth exploring, investors should keep this in mind: Anomalies can appear, disappear, and reappear with little warning. Therefore, mechanically following any type of trading strategy may be risky, but paying attention to these seven moments may bring rewards to keen investors.

Key points

  • Market abnormalities may be a good opportunity for investors.
  • Anomalies should influence but not dominate trading decisions.
  • A proper study of the company’s financial situation is even more important for long-term growth.
  • Most market anomalies are psychologically driven.
  • There is no way to prove these anomalies, because their proof will flood the market in their direction, causing anomalies in themselves.

1. Small companies often outperform the market

Smaller companies (that is, smaller capital) are often better than larger companies. With the occurrence of abnormal situations, the small company effect makes sense. The economic growth of a company is ultimately the driving force behind its stock performance. Compared with large companies, small companies have a much longer growth trajectory.

Companies like Microsoft (MSFT) may need an additional $10 billion in sales to increase by 10%, while smaller companies may only need an additional $70 million in sales to achieve the same growth rate. Therefore, small companies are usually able to grow faster than large companies.

2. The January effect

The January effect is a well-known anomaly. The idea here is that stocks that underperformed in the fourth quarter of last year tended to outperform the January market. The reason for the January effect is so logical that it is almost hard to call it an anomaly. Investors usually sell underperforming stocks at the end of the year so that they can use their losses to offset capital gains taxes (or, if there is a net capital loss that year, they can make small deductions allowed by the IRS). Many people refer to this incident as the “Tax Loss Harvest.”

Since selling pressure is sometimes unrelated to the company’s actual fundamentals or valuation, this “tax selling” can push these stocks to levels that are attractive to buyers in January. Similarly, investors generally avoid buying underperforming stocks in the fourth quarter and wait until January to avoid falling into a tax-loss sell-off. Therefore, there was over-selling pressure before January, and over-buying pressure after January 1, leading to this effect.

3. Low book value

Extensive academic research shows that stocks with below-average price-to-book ratios tend to outperform the market. Many test portfolios indicate that buying a set of stocks with low price-to-book ratios will provide out-of-market performance.

Although this anomaly makes sense to a certain extent-unusually cheap stocks should attract buyers’ attention and return to the mean-unfortunately, this is a relatively weak anomaly. Although the overall performance of low price-to-book ratio stocks is indeed better than that of the market, personal performance is unique and requires a very large portfolio of low price-to-book ratio stocks to see returns.

4. Neglected stocks

As a close relative of the “small company anomaly,” so-called neglected stocks are also considered to outperform the broader market average. The neglected corporate effect occurs on stocks that are less liquid (lower trading volume) and tend to receive the least analyst support. The idea here is that as these companies are “discovered” by investors, stocks will outperform the market.

Many investors monitor long-term buying indicators such as price-to-earnings ratio and RSI. These tell them whether the stock has been oversold, and whether it is time to consider increasing holdings.

Studies have shown that this anomaly is actually not the case-once the impact of market value differences is eliminated, there will be no real outstanding performance.Therefore, the neglected company and Small stocks tend to outperform the broader market (because they are small), but the overlooked large stocks do not seem to perform better than expected. That being said, there is a slight benefit to this anomaly-although their performance seems to be scale-related, neglected stocks do seem to have lower volatility.

5. Reversal

Some evidence shows that within a period of time (usually a year), stocks at the ends of the performance range will indeed reverse in the following period-yesterday’s best-performing stocks will become tomorrow’s under-performing stocks, and vice versa The same is true.

Not only does statistical evidence support this, but based on investment fundamentals, this anomaly is also meaningful. If a stock performs best in the market, it is probably because its performance makes it expensive; similarly, for underperforming people, the situation is just the opposite. Therefore, it seems common sense to expect that overpriced stocks will underperform the market (to bring their valuations back to consistency) and underpriced stocks to outperform the market.

Reversals may also work to a certain extent, because people expect them to work. If enough investors habitually sell last year’s winners and buy last year’s losers, this will help to accurately push the stock in the expected direction, making it a self-fulfilling anomaly.

6. Day of the week

Effective market proponents hate the “day of the week” anomaly because it not only looks real, but also makes no sense. Research shows that stocks tend to fluctuate more on Friday than Monday, and Friday’s market performance tends to be positive. This is not a huge difference, but it is a lasting difference.

Fundamentally, there is no particular reason why this should be correct. Some psychological factors may be at work. As traders and investors look forward to the weekend, the optimism of the weekend may fill the market. Or maybe the weekend gives investors a chance to keep up with their readings, worries and worries about the market, and form pessimism before Monday.

7. Dog of the Dow

The Dow Jones Index is listed as an example of unusually dangerous trading. The idea behind this theory is basically that investors can beat the market by choosing stocks with certain value attributes in the Dow Jones Industrial Average.

Investors have adopted different versions of the method, but there are two common methods. The first is to select the 10 Dow stocks with the highest yields. The second method is to go one step further and take the five stocks with the lowest absolute stock prices from the list and hold them for one year.

It is not clear whether this method has any factual basis, because some people think it is a product of data mining. Even if it worked, the impact will be arbitraged—for example, those who choose a day or a week before the first day of the year.

To some extent, this is just a modified version of the reversal anomaly; the Dow stocks with the highest yields may perform relatively poorly and are expected to outperform the market.

Bottom line

Trying to trade abnormally is a risky investment method. Many anomalies are not real from the beginning, but they are also unpredictable. More importantly, they are usually the product of large-scale data analysis that looks at a portfolio of hundreds of stocks that provide only partial performance advantages.

Similarly, it seems reasonable to try to sell loss-making investments before tax losses actually rise and to postpone the purchase of underperforming investments until at least December.

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