Learning Outcomes
After reading this article, you will be able to explain the principal market anomalies related to momentum, describe the psychological foundations of the representativeness bias, and discuss how investor overreaction affects market prices and the ability of arbitrageurs to correct mispricings. You will learn to recognize the conditions under which anomalies persist and determine their practical implications for investment management and CFA exam scenarios.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand the behavioral foundations of persistent market anomalies. In particular, revision should focus on:
- Explaining the emergence and persistence of market anomalies such as momentum
- Describing how cognitive biases, including representativeness and overreaction, influence investor behavior and security prices
- Discussing practical limits to arbitrage and the reasons anomalies can persist despite the actions of rational traders
- Analyzing the risk/return consequences for portfolios and the difficulties presented by anomalies for efficient market models
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Define momentum as a market anomaly and discuss why it contradicts the efficient market hypothesis.
- Give an example of representativeness bias and outline its effect on investor portfolio construction.
- How does overreaction in financial markets create opportunities and challenges for arbitrageurs?
- Explain what is meant by “limits to arbitrage” in the context of persistent behavioral anomalies.
Introduction
Market anomalies are persistent patterns in returns that contradict the predictions of traditional finance models. This article focuses on momentum, the representativeness bias, and investor overreaction—three concepts often tested at CFA Level 3. The discussion covers their behavioral origins, how they disrupt market efficiency, and why they continue despite rational arbitrage.
Key Term: market anomaly
An observable pattern in financial returns that is inconsistent with standard asset pricing models and cannot be explained by risk alone.Key Term: momentum
The tendency for securities that have performed well (poorly) in the recent past to continue performing well (poorly) over subsequent periods.Key Term: representativeness bias
A cognitive error where investors judge the probability or value of an event based on how closely it matches a prototype, often leading to neglect of base rates.Key Term: overreaction
A behavioral pattern where investors place excessive weight on recent or salient news, causing prices to deviate from fundamental values.Key Term: limits to arbitrage
Real-world constraints that prevent rational traders from quickly correcting mispricings caused by irrational market participants.
THE MOMENTUM ANOMALY
Momentum refers to the empirical finding that stocks with high past returns over short to intermediate horizons tend to earn higher future returns than those with poor past performance. This finding is at odds with the efficient market hypothesis (EMH), which predicts that past returns should have no predictive power.
Momentum effects are widely documented in equity, commodity, and global asset markets. The effect typically persists over a 3 to 12-month time frame and is robust to various risk adjustments.
Psychological Drivers
Momentum arises partly because of behavioral biases:
- Representativeness: Investors conclude that recent winners are fundamentally superior and expect trends to persist, leading to price extrapolation.
- Overreaction: News or recent disclosures are overweighted. Investors chase returns, reinforcing trends.
Worked Example 1.1
A fund manager notices that technology stocks have outperformed for six months. She increases her portfolio allocation to the sector, expecting outperformance to continue. What behavioral bias is this and how might it influence portfolio risk?
Answer:
This is an example of representativeness bias, where the manager assumes recent sector performance is indicative of future outcomes without considering fundamental valuations or risks. This may lead to concentrated positions and increased portfolio risk if trends reverse.
REPRESENTATIVENESS BIAS IN INVESTMENT DECISION-MAKING
Representativeness bias causes investors to believe that a small set of recent data (such as a strong quarter) indicates a permanent change in fundamentals. Rather than integrating long-term probabilities (base rates), investors classify information according to stereotypes or salient events.
This effect explains return-chasing behaviors and the tendency to overvalue recent winners while undervaluing laggards.
Exam Warning Misidentifying the base rate when estimating future returns can lead to overestimating the success probability of "hot" managers or stocks. Always check whether base rate information is being neglected on the exam.
OVERREACTION AND LIMITS TO ARBITRAGE
When investors overreact, prices move excessively in response to current information, deviating from their fundamental value. This creates both short-term momentum (price trends) and long-term reversals, where corrections occur.
Key Term: overreaction
Occurs when investors place too much weight on new or salient news, leading to exaggerated price movements and potential asset mispricings.
Although these mispricings seem like opportunity for arbitrage, there are several barriers:
- Short-sale constraints: Some investors cannot or will not sell short.
- Implementation costs: Trading large or illiquid positions is costly.
- Noise trader risk: Arbitrageurs risk further mispricing before mean reversion occurs, potentially realizing losses short-term.
Key Term: limits to arbitrage
Real-world frictions—such as transaction costs, institutional constraints, and risk of further divergence—that reduce or delay the effectiveness of rational trading strategies.
Worked Example 1.2
A value hedge fund identifies an overheated growth stock with poor fundamentals. Due to inability to borrow shares and high transactions costs, it cannot short the stock in size. The stock price continues to rise before eventually collapsing. What prevented the arbitrage?
Answer:
Limits to arbitrage restricted the hedge fund's ability to profit from the mispricing. Short-sale constraints, stock lending availability, and the risk of further price rises deterred aggressive action. Meanwhile, overreaction and representativeness among retail investors temporarily supported inflated prices.
WHY ANOMALIES PERSIST
The persistence of anomalies like momentum is due to a combination of psychological factors (representativeness, overreaction, trend-chasing) and practical frictions that inhibit arbitrage. Even if prices eventually revert to fundamentals, "limits to arbitrage" can allow mispricings to persist for extended periods, affecting investment performance and challenging classical market efficiency assumptions.
Revision Tip
The CFA exam often tests the practical limits to arbitrage. Always consider both the behavioral origins of anomalies and the real-world market frictions that prevent rapid correction.
Summary
Market anomalies such as momentum, combined with behavioral biases like representativeness and overreaction, create persistent deviations from asset pricing models. Arbitrage is not always effective due to implementation constraints and risk. For the CFA exam, be prepared to explain both psychological and practical drivers of persistent anomalies and recognize their impact on portfolios, risk management, and market efficiency arguments.
Key Point Checklist
This article has covered the following key knowledge points:
- Define momentum and explain its contradiction with market efficiency
- Describe representativeness bias and its impact on belief updating and portfolio risk
- Explain how overreaction leads to price deviations and trend amplification
- Identify main limits to arbitrage that hinder correction of mispricings
- Apply these principles to CFA-style questions on behavioral anomalies
Key Terms and Concepts
- market anomaly
- momentum
- representativeness bias
- overreaction
- limits to arbitrage