**3. Market Anomalies**

There are many market anomalies that are important areas of theoretical and practical interest in Behavioral Finance. As many market anomalies have been observed that EMH cannot explain, many academics have to think of a new theory to explain market anomalies found, and this make a very important new area in finance, Behavioral Finance, which can be used to explain many market anomalies. We discuss some market anomalies in this section and discuss Behavioral Finance in the next section.

## *3.1. Winner–Loser E*ff*ect*/*Reversal E*ff*ect*

De Bondt and Thaler (1985, 1987) found that investors are too pessimistic about the past loser portfolio and too optimistic about the past winner portfolio, resulting in the stock price deviating from its basic value. After a period of time, when the market is automatically correct, past losers are winning positive excess returns, while past winners are having negative excess returns, which support the Winner–Loser Effect. In particular, stocks used in the experiment of De Bondt and Thaler (1985) are those top 35 and those worst 35 in the long-term (five years period), then a return reversal happens in the next three years. Thus, a new method can be advanced to predict stock returns: using reversal strategy to buy the loser portfolio in the past three to five years and sell the winner portfolio.

This strategy enables investors to obtain excess returns in the next three to five years. Further, Jegadeesh (1990) and Lehmann (1990), respectively, proved that return reversal also happens in the short-term. The representative heuristic (Tversky and Kahneman 1974), for example, people tend to rely too heavily on small samples and rely too little on large samples, inadequately discount for the regression phenomenon, and discount inadequately for selection bias in the generation or reporting of evidence (Hirshleifer 2001), can be used to explain the Winner–Loser Effect.

Thus, due to the existence of representative heuristics, investors show excessive pessimism about the past loser portfolio and excessive optimism about the past winner portfolio, that is, investors overreact to both good news and bad news. This will lead to the undervaluation of the loser portfolio price and the overvaluation of the winner portfolio price, causing them to deviate from their basic values.
