Michael M. Pompian - Behavioral Finance and Your Portfolio

1 The “Weak” form contends that all past market prices and data are fully reflected in securities prices; that is, technical analysis is of little or no value.

2 The “Semi-strong” form contends that all publicly available information is fully reflected in securities prices; that is, fundamental analysis is of no value.

3 The “Strong” form contends that all information is fully reflected in securities prices; that is, insider information is of no value.

If a market is efficient, then no amount of information or rigorous analysis can be expected to result in outperformance of a selected benchmark. An efficient market can basically be defined as a market wherein large numbers of rational investors act to maximize profits in the direction of individual securities. A key assumption is that relevant information is freely available to all participants. This competition among market participants results in a market wherein, at any given time, prices of individual investments reflect the total effects of all information, including information about events that have already happened, and events that the market expects to take place in the future. In sum, at any given time in an efficient market, the price of a security will match that security's intrinsic value.

At the center of this market efficiency debate are the actual portfolio managers who manage investments. Some of these managers are fervently passive, believing that the market is too efficient to “beat”; some are active managers, believing that the right strategies can consistently generate alpha (alpha is performance above a selected benchmark). In reality, active managers have a hard time beating their benchmarks. This may explain why the popularity of exchange-traded funds (ETFs) has exploded and why venture capitalists are now supporting new ETF companies, many of which are offering a variation on the basic ETF theme.

The implications of the efficient market hypothesis are far-reaching. Most individuals who trade stocks and bonds do so under the assumption that the securities they are buying (selling) are worth more (less) than the prices that they are paying. If markets are truly efficient and current prices fully reflect all pertinent information, then trading securities in an attempt to surpass a benchmark is a game of luck, not skill.

The market efficiency debate has inspired literally thousands of studies attempting to determine whether specific markets are in fact “efficient.” Many studies do indeed point to evidence that supports the efficient market hypothesis. Researchers have documented numerous, persistent anomalies, however, that contradict the efficient market hypothesis. There are three main types of market anomalies: Fundamental Anomalies, Technical Anomalies, and Calendar Anomalies.

Irregularities that emerge when a stock's performance is considered in light of a fundamental assessment of the stock's value are known as fundamental anomalies. Many people, for example, are unaware that value investing—one of the most popular and effective investment methods—is based on fundamental anomalies in the efficient market hypothesis. There is a large body of evidence documenting that investors consistently overestimate the prospects of growth companies and underestimate the value of out-of-favor companies.

One example concerns stocks with low price-to-book-value (P/B) ratios. Eugene Fama and Kenneth French performed a study of low price-to-book-value ratios that covered the period between 1963 and 1990. 11 The study considered all equities listed on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the Nasdaq. The stocks were divided into 10 groups by book/market and were reranked annually. The lowest book/market stocks outperformed the highest book/market stocks 21.4 percent to 8 percent, with each decile performing more poorly than the previously ranked, higher-ratio decile. Fama and French also ranked the deciles by beta and found that the value stocks posed lower risk and that the growth stocks had the highest risk. Another famous value investor, David Dreman, found that for the 25-year period ending in 1994, the lowest 20 percent P/B stocks (quarterly adjustments) significantly outperformed the market; the market, in turn, outperformed the 20 percent highest P/B of the largest 1,500 stocks on Compustat. 12

Securities with low price-to-sales ratios also often exhibit performance that is fundamentally anomalous. Numerous studies have shown that low P/B is a consistent predictor of future value. In What Works on Wall Street, however, James P. O'Shaughnessy demonstrated that stocks with low price-to-sales ratios outperform markets in general and also outperform stocks with high price-to-sales ratios. He believes that the price/sales ratio is the strongest single determinant of excess return. 13

Low price-to-earnings ratio (P/E) is another attribute that tends to anomalously correlate with outperformance. Numerous studies, including David Dreman's work, have shown that low P/E stocks tend to outperform both high P/E stocks and the market in general. 14

Ample evidence also indicates that stocks with high dividend yields tend to outperform others. The Dow Dividend Strategy counsels purchasing the 10 highest-yielding Dow stocks.

Another major debate in the investing world revolves around whether past securities prices can be used to predict future securities prices. “Technical analysis” encompasses a number of techniques that attempt to forecast securities prices by studying past prices. Sometimes, technical analysis reveals inconsistencies with respect to the efficient market hypothesis; these are technical anomalies. Common technical analysis strategies are based on relative strength and moving averages, as well as on support and resistance. While a full discussion of these strategies would prove too intricate for our purposes, there are many excellent books on the subject of technical analysis. In general, the majority of research-focused technical analysis trading methods (and, therefore, by extension, the weak-form efficient market hypothesis) finds that prices adjust rapidly in response to new stock market information and that technical analysis techniques are not likely to provide any advantage to investors who use them. However, proponents continue to argue the validity of certain technical strategies.

One calendar anomaly is known as “The January Effect.” Historically, stocks in general and small stocks in particular have delivered abnormally high returns during the month of January. Robert Haugen and Philippe Jorion, two researchers on the subject, note that “the January Effect is, perhaps, the best-known example of anomalous behavior in security markets throughout the world.” 15 The January Effect is particularly illuminating because it hasn't disappeared, despite being well known for 25 years (according to arbitrage theory, anomalies should disappear as traders attempt to exploit them in advance).

The January Effect is attributed to stocks rebounding following year-end tax selling. Individual stocks depressed near year-end are more likely to be sold for tax-loss harvesting. Some researchers have also begun to identify a “December Effect,” which stems both from the requirement that many mutual funds report holdings as well as from investors buying in advance of potential January increases.

Additionally, there is a Turn-of-the-Month Effect. Studies have shown that stocks show higher returns on the last and on the first four days of each month relative to the other days. Frank Russell Company examined returns of the Standard & Poor's (S&P) 500 over a 65-year period and found that U.S. large-cap stocks consistently generate higher returns at the turn of the month. 16 Some believe that this effect is due to end-of-month cash flows (salaries, mortgages, credit cards, etc.). Chris Hensel and William Ziemba found that returns for the turn of the month consistently and significantly exceeded averages during the interval from 1928 through 1993 and “that the total return from the S&P 500 over this sixty-five-year period was received mostly during the turn of the month.” 17 The study implies that investors making regular purchases may benefit by scheduling those purchases prior to the turn of the month.