Hello Tigers!
In the previous session, I introduced you to a practical behavioral finance strategy — the long-term reversal strategy, which follows the principle of “what goes up for too long must come down, and what goes down for too long must go up.” In this lesson, we’ll explore a new concept: the financial report anomaly, and the investment opportunities it presents.
What are financial report anomalies?
An anomaly refers to an abnormal phenomenon that contradicts the traditional finance theory of risk-return correspondence. Traditional theory teaches that the higher the return, the greater the risk. However, behavioral finance strategies have found that investors can sometimes gain higher returns without taking on more risk — these opportunities are called anomalies. However, like all investment strategies, anomalies are subject to market risks and do not guarantee returns.
Asset managers and fund companies treat these anomalies as valuable information. By identifying financial report anomalies, they design strategies that generate excess returns. These strategies rely on recognizing patterns that most investors overlook.
Understanding the accrual anomaly
Among various financial report anomalies, the accrual anomaly is one of the best known. “Accruals” are accounting items that should be included in financial statements but have not yet been realized — such as accounts receivable, accounts payable, and inventory.
In 1996, Professor Sloan from the University of Pennsylvania discovered this phenomenon. He found that buying stocks of companies with lower accrual items and shorting those with higher accrual items could yield positive excess returns. This discovery led to what’s now known as the accrual anomaly trading strategy. [1]
Why the accrual anomaly works
Many investors focus too much on “earnings per share” (EPS) and ignore the quality of those earnings. Two companies might report the same EPS, but one’s earnings could come mostly from accruals rather than actual cash flow. The market often overlooks this difference, causing mispricing.
By going long on low-accrual stocks and short on high-accrual ones, investors can capture this behavioral inefficiency. Studies show this strategy produced positive excess annualized returns in 29 out of 30 sample years.
The accrual anomaly reveals that accounting details can predict future stock performance — a cornerstone concept in behavioral finance strategies.
Strategy | Key metric | Trading action | Typical annual excess return |
Accrual anomaly | Total accruals | Buy low-accrual, short high-accrual | 5–10% |
Earnings anomaly | Earnings surprise | Buy positive-surprise, short negative-surprise | 10% (within 60 days) |
The earnings anomaly and market reactions
Another important financial report anomaly is the earnings anomaly, sometimes called the post-earnings announcement drift. Professors Bernard (University of Michigan) and Thomas (Columbia University) found that companies announcing good earnings news tend to see their stock prices continue rising, while those with bad news keep falling.[2]
How earnings surprises drive stock prices
The market doesn’t fully absorb earnings news immediately. Instead, the reaction drifts over time — this is known as the earnings surprise effect. When analysts expect a company to grow profits by 200%, and it achieves exactly that, there’s no “surprise.” But if another firm grows only 100% yet far exceeds expectations, its stock can outperform due to positive surprise.
By ranking companies according to the difference between actual and expected earnings and going long on positive surprises while shorting negative ones, investors can capture excess returns over the following 60 days — averaging more than 10% annually in long-term studies.
This phenomenon shows how investor psychology and delayed reactions can create consistent trading opportunities.
Key takeaways on behavioral finance strategies
Financial report anomalies highlight inefficiencies in how investors interpret accounting data.
Accrual anomalies show that earnings quality matters as much as earnings level.
Earnings anomalies prove that markets often underreact to surprises.
Behavioral finance strategies can systematically exploit these in efficiencies for long-term gains.
In the next lesson, we’ll explore behavioral finance principles in long-term investing.
Reference
[1] Sloan, R. G. (1996). Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? The Accounting Review, Vol. 71, No. 3, pp. 289–315. https://www.jstor.org/stable/248290
[2] Bernard, V. L., & Thomas, J. K. (1989). Post-Earnings-Announcement Drift: Delayed Price Response or Risk Premium? Journal of Accounting Research, 27, 1–36. https://doi.org/10.2307/2491062
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