Strategic Financial Management · Efficient Market Hypothesis

Market Anomalies and Criticisms of the Efficient Market Hypothesis

Updated 11 October 2026 · Fact-checked

A market anomaly is a pattern in returns that the Efficient Market Hypothesis cannot explain, such as the January effect, size effect or bubbles. Behavioural finance adds that investors are not fully rational. To answer exam questions, define the anomaly, state the EMH form it challenges, give the cause, and conclude.

Understand Market Anomalies and Criticisms of EMH

The Efficient Market Hypothesis (EMH) says prices already reflect available information, so you cannot earn abnormal returns, meaning returns above what the risk justifies, by using that information. An anomaly is an observed pattern that seems to break this rule.

The common anomalies are these:

January effect: Returns in January have often been higher than in other months, especially for small stocks. A usual explanation is tax-loss selling in December followed by buying back in January. This challenges weak-form efficiency, because a calendar pattern could be used to trade.
Size effect: Small-company shares have often earned higher risk-adjusted returns than large-company shares. Critics say the market misprices small firms. Defenders say small firms carry extra risk, such as low liquidity, and that the CAPM does not capture it.
Other calendar effects: Examples are the weekend (Monday) effect and the turn-of-the-month effect.
Value effect: Low price-to-earnings or low price-to-book shares have often outperformed. This challenges semi-strong efficiency.
Momentum: Recent winners keep winning for a while, which suggests price trends can be used.
Bubbles and crashes: Prices rise far above fundamental value and then fall sharply. This is hard to square with prices always equalling intrinsic value.

A key point is the joint hypothesis problem. Any test of EMH also tests an asset pricing model, such as CAPM, that defines normal return. If an anomaly appears, either the market is inefficient or the model is wrong. You cannot be sure which.

Behavioural finance attacks the assumption that investors are rational. It points to biases such as overconfidence, herding, anchoring, loss aversion and representativeness. It also says arbitrage is limited: even if prices are wrong, arbitrageurs face risk, cost and short horizons, so mispricing can persist.

Supporters of EMH reply that many anomalies are weak, vanish once discovered, depend on the sample period, or disappear after transaction costs. Most students should conclude that markets are largely, but not perfectly, efficient.

Key rules to remember

Abnormal return: Abnormal return = Actual return − Expected (required) return; Expected return comes from a model such as CAPM. An anomaly means persistent non-zero abnormal returns.
CAPM expected return: E(R) = Rf + β × (Rm − Rf); Used to test whether a pattern gives returns beyond what risk explains.
Joint hypothesis rule: Test of efficiency = Test of market + Test of pricing model; A rejection may mean the model is wrong rather than the market being inefficient.

How to solve Market Anomalies and Criticisms of EMH questions

Use this method for a short note, a discussion question or a case-based question on anomalies and criticisms.

1Define EMH in one line and name the form (weak, semi-strong or strong) the point relates to.
2Define the anomaly in plain words and give its pattern, for example higher January returns for small stocks.
3State why it conflicts with EMH: it implies a rule-based strategy could earn abnormal returns.
4Give the explanations: risk-based or model failure, tax and liquidity factors, or behavioural biases.
5If numbers are given, compute abnormal return as actual return minus CAPM expected return.
6Add the counter-argument: transaction costs, disappearance after discovery, and the joint hypothesis problem.
7Close with a balanced conclusion and, for a case, a recommendation to the investor.

Quickest way: Anomaly, EMH form, cause, verdict

When to use it: For 2-mark MCQs and short notes when time is tight.

Identify the anomaly from its pattern: month, firm size, value ratio, trend or price spike.
Match it to the EMH form it challenges: calendar and momentum to weak, value and size to semi-strong.
Write one cause: tax selling, risk premium, or a behavioural bias.
End with the verdict: evidence is mixed and costs may remove the profit.

Common mistakes in Market Anomalies and Criticisms of EMH

Saying an anomaly proves that EMH is false.
Students treat any pattern as final proof.
Fix: Mention the joint hypothesis problem and that many anomalies fade or vanish after costs.
Linking the January effect to strong-form efficiency.
The three forms get mixed up.
Fix: Link calendar patterns to weak form, since they use past data or timing only.
Confusing the size effect with large-cap outperformance.
Students assume bigger firms do better.
Fix: The size effect refers to small firms earning higher returns than a risk model predicts.
Writing behavioural finance as simply 'investors are irrational' with no biases named.
Students remember the idea but not the detail.
Fix: Name at least three biases, such as overconfidence, herding and loss aversion, and mention limits to arbitrage.
Treating a bubble as a small price rise.
The word is used loosely.
Fix: Define a bubble as prices rising well above intrinsic value, often driven by herding, followed by a sharp correction.

Worked examples

Example 1

A small-cap portfolio has β = 1.2 and earned 18% in a year. The risk-free rate is 6% and the market return is 13%. Is there an abnormal return, and what does it suggest about the size effect?

Show the solution

Expected return = 6% + 1.2 × (13% − 6%).
= 6% + 1.2 × 7% = 6% + 8.4% = 14.4%.
Abnormal return = 18% − 14.4% = 3.6%.
A positive 3.6% is consistent with a size effect, but one year is not proof.

Answer: The abnormal return is +3.6%. It points to a size effect, but because of the joint hypothesis problem it could reflect a missing risk factor, and a single year is too short a sample to conclude.

Example 2

Write a short note on how behavioural finance challenges the Efficient Market Hypothesis.

Show the solution

EMH assumes rational investors, so prices equal intrinsic value.
Behavioural finance says investors have biases: overconfidence causes excess trading, herding causes bubbles, loss aversion causes holding losers too long, and anchoring ties judgment to past prices.
These biases can push prices away from value, which explains bubbles, crashes and momentum.
Limits to arbitrage mean rational traders may be unable to correct mispricing quickly because of risk, costs and short horizons.
EMH supporters reply that biases may cancel out, and that anomalies often disappear or yield no profit after costs.

Answer: Behavioural finance challenges EMH by showing that psychological biases and limits to arbitrage can keep prices away from fundamental value. The evidence is mixed, so markets are largely but not perfectly efficient.

Exam tips

Always name the EMH form that the anomaly challenges; it earns easy marks.
In a short note, use a clear structure: meaning, examples, explanation, counter-view, conclusion.
Mention the joint hypothesis problem whenever the question asks you to evaluate evidence.
In case scenarios, advise the investor that profit after transaction costs and taxes matters.
Do not quote specific return figures for anomalies unless the question gives them.

Practice questions from Efficient Market Hypothesis

Market Anomalies and Criticisms of EMH: frequently asked questions

What is the January effect?

It is the tendency for stock returns, especially of small companies, to be higher in January than in other months. Tax-loss selling in December and reinvestment in January are common explanations. It challenges weak-form efficiency.

What is the size effect in EMH?

It is the observation that small-company shares have often earned higher risk-adjusted returns than large-company shares. Some see it as mispricing, while others see compensation for extra risk like low liquidity.

How is behavioural finance different from EMH?

EMH assumes rational investors and prices that reflect information. Behavioural finance says biases such as herding and overconfidence can cause lasting mispricing, and that arbitrage is limited.

Do anomalies mean investors can earn easy profits?

Not necessarily. Many anomalies weaken once known, are unstable across periods, or vanish after transaction costs and taxes.