Unit 7 Assignment

Description of a behavioral anomaly to be exploited (or corrected). This must include specific behavioral biases and an explanation of how these biases lead to the observed behavior/anomaly, including why market forces alone may not act to eliminate them.

Evaluating Major Anomalies

FIN402_30: Bahavioral Finance in Personal Investment

Evaluating Major Anomalies

Economic decision-making is influenced by psychological and social factors. Behavioral finance studies these factors. It challenges the traditional assumptions of modern finance, such as the EMH and the CAPM, by highlighting the existence of anomalies in financial markets (Antony, 2020). These anomalies, such as the “lagged reactions to earnings announcements, small-firm effect, value advantage, momentum, and reversal,” suggest that markets cannot be as effective as previously thought.

Lagged Reactions to Earnings Announcements

The lagged reactions to earnings announcements are an anomaly that occurs when stock prices do not respond immediately to the release of earnings reports. Instead, there is a delay in the reaction, suggesting that investors may still need to process the information in the report fully. This anomaly challenges the efficient market hypothesis (EMH), which assumes that all relevant information is immediately incorporated into stock prices (Wang, Faff & Zhu, 2022). The potential effects of the lagged reactions to earnings announcements are many. Firstly, it can lead to a mispricing of stocks in the short term. If investors do not react immediately to the release of earnings reports, stock prices may not reflect the company’s true value. This can lead to opportunities for informed investors to take advantage of the mispricing and make profitable trades.

Secondly, the lagged reactions can also lead to a lack of confidence in the market. If investors perceive that the market needs to react immediately to important information, they may be less likely to invest in the market. This could cause a reduction in liquidity and lower overall market efficiency (Sattar, Toseef & Sattar, 2020). Thirdly, the lagged reactions may also lead to increased volatility in the market. If investors do not react immediately to the release of earnings reports, stock prices may fluctuate more than they would if investors were able to process the information more quickly. This increased volatility can make it harder for investors to make profitable trades.

Small-firm Effect

The small-firm effect is an anomaly in finance that suggests that small-cap stocks tend to outdo large-cap stocks over the long term. This is a phenomenon that contradicts the “Capital Asset Pricing Model (CAPM),” which predicts that riskier assets should have higher returns (Areiqat et al., 2019). The small-firm effect, sometimes known as the “size impact,” argues that investors may underestimate small-cap shares, resulting in greater profits for those who trade in them. One potential explanation for the small-firm effect is that small-cap stocks are less researched and followed by analysts, leading to a need for more information about these companies. This lack of information may make small-cap stocks appear riskier than they actually are, leading to undervaluation.

Additionally, small-cap stocks may be more susceptible to market sentiment and fluctuations, which can make them more volatile than large-cap stocks. However, over the long term, the returns on these stocks may be higher. Another potential explanation for the small-firm effect is that small-cap stocks have more opportunity for growth than large-cap stocks (Pandey & Joshi, 2021). As small-cap companies grow and become more successful, their stock prices may rise, leading to higher returns for investors.

The small-firm effect has a number of potential effects on the financial markets. For one, small-cap stocks may be undervalued by investors, leading to higher returns for those who invest in them. Additionally, the small-firm effect may also lead to increased volatility in the markets, as small-cap stocks may be more susceptible to market sentiment and fluctuations (Pandey & Joshi, 2021). Furthermore, the small-firm effect may also lead to increased risk for investors, as small-cap stocks may need more research and followed by analysts. This lack of information can make it more difficult for investors to make informed decisions about these stocks.

Value Advantage

Long-term value stocks outperform growth stocks due to the value advantage. This anomaly challenges the Capital Asset Pricing Model (CAPM), which predicts higher-risk assets should have higher returns. The value advantage suggests that value stocks may be undervalued by investors, leading to higher returns for those who invest in them (Sattar, Toseef & Sattar, 2020).
Value stocks are typically defined as companies with a low price-to-book ratio, a low price-to-earnings ratio, and high dividends. These companies often have a history of steady earnings, a strong balance sheet, and a solid track record of paying dividends. On the other hand,
growth stocks are typically defined as companies with high earnings growth potential and are anticipated to mature faster than the overall market.

The value advantage can have several potential effects on the market. Firstly, it can lead to the underperformance of growth stocks and the outperformance of value stocks. This can negatively impact investors, with a significant portion of their portfolio invested in growth stocks (Sattar, Toseef & Sattar, 2020). Secondly, it can lead to the undervaluation of value stocks, which can create opportunities for investors to buy undervalued stocks at a lower price. Thirdly, it can lead to a higher return on investment for value stock investors in the long term.

Additionally, the value advantage can also have an effect on the overall market. It can lead to a revaluation of value stocks, which can result in an increase in the overall market value. It can also lead to a shift in investor preferences, with more investors opting to invest in value stocks over growth stocks. This can lead to a change in the composition of the market. With a higher percentage of the value, the stocks are being traded.

Momentum

Momentum is a financial market oddity that says that stocks that have fared well in the past will likely keep performing well in the future. A contrary proposition to the efficient market hypothesis (EMH) is this, which says that all information is instantaneously integrated into stock prices and that previous performance does not forecast future results, this is the case. The momentum effect is often observed in both stock and commodity markets.

The momentum effect has several potential effects on the financial markets. Firstly, it can create inefficiencies in the market as investors may overpay for stocks currently performing well and undervalue those performing poorly (Sattar, Toseef & Sattar, 2020). Secondly, it can lead to increased volatility in the markets as the trend of high-performing stocks may change abruptly, and investors may be caught off guard. Additionally, the momentum effect may affect the performance of actively managed funds, investors who tend to buy stocks based on past performance and sell stocks based on recent performance. However, the momentum effect can also lead to underperformance for these funds as the trend may change abruptly, and they may be left holding overvalued stocks.

Reversal

The reverse is an oddity in behavioral finance that predicts that stocks that have historically underperformed are likely to continue to underperform in the future. In contrast, the momentum effect predicts that equities. That who have done well in the past will likely continue to do so. The reversal effect can have several potential effects on investors and the market as a whole. One potential effect is that it can lead to underperformance for investors who continue to hold onto losing stocks in the hope that they will recover in the future (Sattar, Toseef & Sattar, 2020). This is because the reversal effect suggests that stocks have performed poorly. In the past, they are likely to continue to perform poorly in the future. Another potential effect is that the reversal effect can lead to over-performance for investors who actively trade and take advantage of the effect. For example, an investor who sells losing stocks and buys winning stocks may be able to outperform the market.

In conclusion, behavioral finance is an important field of study because it challenges modern finance’s traditional assumptions and highlights anomalies in financial markets. These anomalies suggest that markets may not be as efficient as previously thought and that investors may not always act rationally. Understanding these anomalies can help investors make more informed decisions and potentially lead to more efficient markets.

References

Antony, A. (2020). Behavioral finance and portfolio management: Review of theory and literature. 
Journal of Public Affairs, 
20(2), e1996.

Areiqat, A. Y., Abu-Rumman, A., Al-Alani, Y. S., & Alhorani, A. (2019). Impact of behavioral finance on stock investment decisions applied study on a sample of investors at Amman stock exchange. 
Academy of Accounting and Financial Studies Journal, 
23(2), 1-17.

Pandey, A., & Joshi, R. (2021). Examining Asset Pricing Anomalies: Evidence from Europe. 
Business Perspectives and Research, 22785337211025712.

Sattar, M. A., Toseef, M., & Sattar, M. F. (2020). Behavioral finance biases in investment decision making. 
International Journal of Accounting, Finance and Risk Management, 
5(2), 69.

Wang, Q., Faff, R., & Zhu, M. (2022). Realized moments and the cross-sectional stock returns around earnings announcements. 
International Review of Economics & Finance, 
79, 408-427.

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Due Date: 11:59 p.m. EST, Sunday of Unit 7
Points: 100

Overview:

This project will be a venue for you to apply the concepts and methods developed in
class in a practical context of your interest. The goal of the project is to develop an
implementable idea that has the potential to generate value in that context.

Instructions:

Choose one of the following perspectives for your project:

a. a portfolio management team looking for a new trading strategy;
b. a consulting firm advising corporations on issues of financial management;
c. an entrepreneurial start-up developing a retail financial product (further

alternatives can be thought of – e.g., social entrepreneurship is a viable venue in
some cases where profit opportunities are not available but correcting a bias
would have great social value).

You will submit your desired topic/idea choice for instructor approval during Unit 2.

In each case, the main deliverable is in the form of a “pitch” to potential clients, which
can include institutional investors in the case of portfolio managers, corporate clients, or
venture capitalists. Your project must contain the following elements:

• Description of a behavioral anomaly to be exploited (or corrected). This must
include specific behavioral biases and an explanation of how these biases lead to
the observed behavior/anomaly, including why market forces alone may not act
to eliminate them.

• Description of the proposed strategy for taking advantage of this anomaly (e.g.,
in the case of asset mispricing) or for correcting the bias, either profitably or with
benefit to society.

• Evidence supporting the idea behind the strategy (why should it succeed?).

• Description of risks and challenges (why might it fail?).

FIN402: Behavioral Finance in Personal Investment

Unit 7 Assignment: Portfolio Management Project

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Requirements:

• The length of the paper should be 6-8 pages and double-spaced with additional
title and reference pages included.

• Begin your pitch with an appropriate introduction and complete it with a related
conclusion.

• Use a minimum of five (5) resources. Academic research journals should make
up at least two (2) of these. You may also cite the course text.

• Proper grammar and APA formatting must be followed.
• See grading criteria on the following page.

Be sure to read the criteria by which your work will be evaluated before you write
and again after you write.

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Evaluation Rubric for Portfolio Management Project

CRITERIA Needs Improvement Satisfactory Proficient

(0-13 Points) (14-17 Points) (18-20 Points)
Analyzes the
Material

The pitch is unclear or
fairly clear but
discussed too broadly
and does not meet
expectations.
Contextual factors are
weakly considered and
lacking in some
significant areas.
Complex issues are
overlooked or handled
without care. The
application is stretched
or not applied.

The pitch is presented,
and all items are
discussed appropriately,
though may be lacking
specific details.
Contextual factors are
considered but can be
expanded on in some
areas. Key terms are
defined, and complex
issues are recognized.

The pitch is clearly
presented, and all items are
discussed in detail.
Contextual factors are
considered. Key terms are
defined, and complex
issues are navigated with
precision.

Pitch Approach Introduction and
conclusion are missing
or may be lacking
details to properly set up
and then wrap up the
essay. The introduction/
conclusion are not
related.

Introduction and
conclusion are included
and set up and wrap up
the essay, though they
could be stronger and/or
relate better.

Introduction and conclusion
effectively set up and wrap
up the essay. The
introduction/ conclusion
relate well to each other and
work together to appeal to
the reader.

Research
Elements

Academic sources are
not used, or there are
few than five (5).
Arguments incorporate
research but often
include personal opinion
without appropriate
support. Sources are, at
times, not used
appropriately. Research
is not aware of multiple
viewpoints of complex
issues.

At least five (5)
academic primary and
secondary materials,
including academic
journal articles, are used
throughout the pitch.
Arguments are
supported with research
materials and are aware
of multiple viewpoints of
complex issues; however
arguments can be more
strongly supported with
research.

At least five (5) academic
primary and secondary
materials, including
academic journal articles,
are appropriately used
throughout the pitch.
Research incorporates
multiple viewpoints of
complex issues and
arguments are correctly and
strongly supported with
research.

Structure and
Flow

Flow is poor.
Paragraphing is
inappropriate.
Transitions are minimal
or absent. Redundancy
is evident.

Flow is good.
Paragraphing is mostly
appropriate. Transitions
are present, and
redundancies are
minimal.

Flow is excellent.
Paragraphing is clear, and
transitions are smooth and
consistent. Inappropriate
redundancies are absent.

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CRITERIA Needs Improvement Satisfactory Proficient
(0-6 Points) (7-8 Points) (9-10 Points)

Clear and
Professional
Writing and APA
Format

Errors impede
professional
presentation; no/minimal
APA guidelines
followed.

Few errors contained
that do not impede
professional
presentation. Some
APA guidelines may not
be followed.

Writing and format are clear,
professional, APA
compliant, and error free.

(0 Points) (10 Points)
Assignment
Length

Assignment length is
significantly less than
or more than
requirement.

N/A Assignment meets length
requirement.