The Rise of Anomalies: Challenging Theory and Practice in Finance

This chapter introduces the basic issues and problems of anomalies, asset pricing, and behavioral finance. Long/short portfolios of stocks not explained by an asset pricing model are considered to be anomalies. However, other important characteristics of anomalies are abnormally high return performance as well as return predictability. Anomalies with high returns that are persistent over time are particularly attractive to investors. According to the efficient market hypothesis (EMH), anomalies with high returns should be arbitraged away by investors and therefore are only transitory in nature. Unfortunately, despite some controversy, empirical evidence has been accumulating over the past 40 years or more that long/short portfolio anomalies are real and not going away. If anomaly portfolios are not efficiently priced, we need to consider the possibility that inefficiencies exist in the market. Behavioralists argue that human psychology allows for irrational investor behavior, which accounts for inefficiencies in the pricing of anomaly portfolios. Other potential sources of anomalies are information asymmetries and market structure. These sources of abnormal returns should be arbitraged away by profit-seeking investors. However, the effects of irrational investor behavior driven by human behavior are likely more difficult to eliminate via arbitrage. The main purpose of this book is to present new stock market evidence on the ability of asset pricing models to explain large datasets of long/short anomaly portfolios. Also, we review published studies on stock market anomalies and asset pricing models. In this chapter, we provide background discussion on the EMH-behavioralist debate. Later chapters review previous empirical tests and report new evidence using open source (online) datasets of long/short anomaly portfolios. Which school of thought does the market evidence support? Efficient markets? Behavioral finance? Or are both schools useful to our understanding of stock prices? As we will see, based on a new asset pricing model dubbed the ZCAPM by Kolari et al. (2021), our empirical evidence in forthcoming chapters strongly favors the EMH.