Before discussing different kinds of behavioural biases, let us first talk about the impact these biases may have on the stock market. You must have heard of the term, Efficient Market Hypothesis - when the stock market reflects all types of information and immediately adapts to new information. This implies that you can neither use technical or fundamental analysis to beat such a market that is fully efficient. Now, we all know that this is highly inaccurate, especially in the case of the Indian stock market. This is because of Adaptive Market Hypothesis wherein behavioural biases lead to anomalies that cause the various cycles, trends, crashes and booms.
Some of the market anomalies are as follows:
1. Momentum - When rising stock prices further cause a rise in that stock’s price and falling prices continue falling. This anomaly indicates that one should always buy past winners and sell past losers even with no new information in the picture. This goes against the principles of finance.
2. Calendar anomalies - Some examples of this type of anomaly are the “January effect” and “Mark Twain Effect”. January effect is when stocks perform exceptionally well in January often owing to investors selling more in December to set off losses for tax benefit or to show high performance at the end of the year.
The Mark Twain effect is related to low returns in the month of October and has got its name from the famous quote by Mark Twain, “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” This statement is actually one of sarcasm which indicates that it is ALWAYS dangerous to trade in stocks but the special emphasis on October is what gave this phenomenon its name.
3. Value Effect - Here, value stocks (low price multiples and high dividend yield) tend to outperform growth stocks (high price multiples and low dividend yield).
4. Earnings Surprise - This is when a company's actual or reported financial numbers are widely different from market/analyst expectations. The analyst expectations are often based on the company’s previous financial reports and the company’s own estimate or guidance in concalls. However, when a positive earnings surprise occurs, the market reacts positively going for a bull run and vice versa. Often, companies purposely give low “guidance” in order to increase their share price on the basis of a positive earnings surprise. This is highly unethical.