Anomalies in the stock market and how to exploit them part 1

Anomalies occur because not all participants in the market are rational and there are behavioral biases that lead to the mispricing of financial assets. In this article you will learn about those anomalies and how to exploit them.

The Size Anomaly

The size anomaly states that small-cap portfolios tend to outperform large-cap portfolios. This is also often called “Small Minus Large” or short SML. To implement a trading strategy that exploits this anomaly you first need to sort the stocks into small and large caps. Thereafter you go long on small caps and short on large caps. After a certain period of time you are required to rebalance your portfolio by repeating the first two steps again.

The Value Anomaly

The value anomaly states that value firms, i.e. firms that have a high book to market ratio, tend to outperform growth firms, i.e. firms that have a low book to market ratio. Therefore it is also often called High Minus Low (HML), referring to high minus low book-to-market ratio. In order to implement a trading strategy that exploits this anomaly, you first need to sort the stocks according to high and low book to market ratio. Afterwards you need to go long on value firms and short growth firms. After a certain period of time you rebalance your portfolio and repeat the same steps.

The Momentum Anomaly

The momentum anomaly states that past winners tend to outperform past losers. Winners in this case are firms with the highest return in the past 12 months and losers are firms with the lowest return in the past 12 months. This anomaly is often also called “Up Minus Low” (UML), where “up” means high past returns and “low” means low past returns. Another term for this anomaly is “Winners Minus Losers” (WML). In order to exploit this anomaly with a trading strategy, you again first need to sort the stocks according to “winners” and “losers”. Then you have to go long on the winners of the past 12 months and short on losers of the past 12 months. After a period of time, you need to rebalance your portfolio again.

The Low Volatility Anomaly

The low volatility anomaly states that low beta assets tend to outperform high beta assets. A common strategy to exploit this anomaly is called “betting against beta”, a strategy that famous investor Warren Buffet is using. For that strategy you need to build a beta neutral (i.e. a zero-beta) portfolio. More specifically, you need to go long on a leveraged portfolio of low-beta assets and go short on a portfolio of high-beta assets.

The Low Risk Anomaly

Another anomaly is the low risk anomaly, which states that quality stocks tend to outperform “junk” stocks. Key quality characteristics for quality stocks are the profitability, the stability of profits and the growth of profits. A famous trading strategy to exploit this anomaly is called Quality Minus Junk (QMJ). To execute this strategy, you need to build a portfolio where you go long on high quality stocks and short on low quality stocks.

Furthermore, there are also "calendar effects", which are anomalies that occur at certain points in time, besides many more anomalies, which we covered in this article.

Key Takeaways:

• Size Anomaly - small-cap outform large-cap portfolios: Go long with small-caps, short large-caps.

• Value Anomaly - value stocks tend outperform growth stocks: Go long with value stocks and short growth stocks

• Momentum Anomaly - past winners tend to outperform past losers: Go long with past winners and short past losers

• Low Volatility Anomaly - low beta assets tend to outperform high beta assets: Go long with low beta assets and short high beta assets.

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• ‍Low Risk Anomaly -  quality stocks tend to outperform junk stocks: Go long on quality stocks and short junk stocks.