Definition: Anomaly represents a case where the actual outcome deviates from the model expectation. Thus, an anomaly occurs when we anticipate a specific result, but the actual event turns out to deviate from our expectations.
An anomaly can reveal fundamental flaws in an assumption. An anomaly can also dislodge a commonly held belief and advance a new understanding of a subject. Any sufficiently advanced model fails to incorporate all relevant observations and input and is vulnerable to challenge. Anomaly is not necessarily an event or circumstance that itself produces an anomaly; instead, it’s the state of affairs that opens up an opportunity for an event or circumstance to behave in unexpected ways.
Types of anomalies in finance
- Market anomalies
Market anomalies are potential mispricing events that can bias your portfolio within the observed range. Anomalies can appear at all times and in all sizes. The efficient market hypothesis (EMH) tells us that price is a function of supply and demand, with supply being equal to available resources and demand being demanded by buyers. But there’s a lot more to markets than that. The anomalies aren’t typically part of the average data, but that can distort prices if enough people send prices tumbling.
- Pricing anomalies
Pricing anomalies occur in many industries and most often are due to supply/demand issues. The fundamental concept is that once a good or service becomes available, suppliers flood the market with their product to capture as much market share as possible before competitors have a chance to match or beat them. As a result, prices may be affected by little more than real-world supply/demand fluctuations. However, there are also some systematic techniques used by technical algorithms to detect pricing anomalies and execute appropriate price interventions.
Types of Market Anomalies
- The January effect is a rather well-known statistical phenomenon: a stock or an investment that underperforms in the fourth quarter tends to perform better in January or later. The January effect has been found in almost all asset classes and has been named by media outlets like Forbes as one of the most important factors influencing stock prices over the long term.
- The September effect is an economic phenomenon in which stocks typically underperform their underlying asset prices in September and November. While the market has been on an upward trajectory since early 2016, September has historically been considered one of the worst months to invest in stocks due to both high expectations and low stock growth expectations for the year as a whole.
Anomalies are everywhere, and the best trader for them is always going to be someone who focuses on the truly useful aspects of his business.