The mispricing explanations are often contentious within academic finance, as academics do not agree on the proper benchmark theory (see Unmeasured Risk, below). This intercept is commonly denoted by the Greek letter alpha:Į ( R t − R f, t ) = α + β is the return on the "market", often proxied by the return on the CRSP index (an index of all publicly traded U.S. The deviation from this theory is measured by a non-zero intercept in an estimated security market line. The most common benchmark is the CAPM (Capital-Asset-Pricing Model). "Mispricing" is then defined as the deviation relative to the benchmark. The mispricing explanation is natural, as anomalies are by definition deviations from a benchmark theory of asset prices. Many, if not most, of the papers which document anomalies attribute them to mispricing (Lakonishok, Shelifer, and Visny 1994, for example). 2 List of anomalies documented in academic journalsĮxplanations for anomalies Mispricing.For example, the well-known size anomaly refers to the fact that stocks with lower market capitalization tend to out-perform stocks with higher market capitalization in the future. Cross-sectional anomalies refer to the predictable out-performance of particular stocks relative to others. These time-series predictors indicate times in which it is better to be invested in stocks vs a safe asset (such as Treasury bills). Time-series anomalies refer to predictability in the aggregate stock market, such as the often-discussed Cyclically Adjusted Price-Earnings (CAPE) predictor. Īnomalies can be broadly categorized into time-series and cross-sectional anomalies. Academics have not reached a consensus on the underlying cause, with prominent academics continuing to advocate for selection bias, mispricing, and risk-based theories.
The four primary explanations for market anomalies are (1) mispricing, (2) unmeasured risk, (3) limits to arbitrage, and (4) selection bias. Relatedly, return predictability by itself does not disprove the efficient market hypothesis, as one needs to show predictability over and above that implied by a particular model of risk. Finally, return predictability may be due to cross-sectional or time-variation in risk, and thus does not necessarily provide a good investment opportunity. Additionally, return predictability declines substantially after the publication of a predictor, and thus may not offer profits in the future. As a result, many anomalies do not offer profits, despite the presence of predictability. Moreover, the studies do not account for trading costs. Almost all documented anomalies focus on illiquid, small stocks. These "anomalies", however, come with many caveats. Īcademics have documented more than 150 return predictors (see List of Anomalies Documented in Academic Journals). Indeed, many academics simply refer to anomalies as "return predictors", avoiding the problem of defining a benchmark theory. Standard theories include the capital asset pricing model and the Fama-French Three Factor Model, but a lack of agreement among academics about the proper theory leads many to refer to anomalies without a reference to a benchmark theory (Daniel and Hirschleifer 2015 and Barberis 2018, for example). Financial market is predictability seems to be inconsistent with theories of asset pricesĪ market anomaly in a financial market is predictability that seems to be inconsistent with (typically risk-based) theories of asset prices.
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