Herd Behavior in Financial Markets

This paper outlines the causes (of)  and empirical evidence for herd behavior in financial markets.

Introduction (Via IMF)

This paper provides an overview of the recent theoretical and empirical research on herd behavior in financial markets. It looks at what precisely is meant by herding, the causes of herd behavior, the success of existing studies in identifying the phenomenon, and the effect that herding has on financial markets.

Additional Excerpts (Via IMF)

In this paper we provide an overview of the recent theoretical and empirical research on rational herd behavior in financial markets. Specifically, we examine what precisely is meant by herding, what are possible causes of rational herd behavior, what success existing studies have had in identifying it, and what effect such behavior has on financial markets.5 In Section I, we discuss how imperfect information, concern for reputation, and compensation structures can cause herding.

Intentional herding may be inefficient and is usually characterized by fragility and idiosyncrasy. It can lead to excess volatility and systemic risk.6 Therefore, it is important to distinguish between true (intentional) and spurious (unintentional) herding. Furthermore, the causes of investor herding are crucial for determining policy responses for mitigating herd behavior. How does one empirically distinguish between informational, reputation-based, and compensation-based herding? One approach would be to examine whether the assumptions underlying some of the theories of herd behavior are satisfied.

A financial asset bought by one market player must be sold by another. Therefore, all market participants cannot be part of a “buying herd” or a “selling herd.” To examine herd behavior, one needs to find a group of participants that trade actively and act similarly. Such a group is more likely to herd if it is sufficiently homogenous (each member faces a similar decision problem), and each member can observe the trades of other members of the group. Also, such a homogenous group cannot be too large relative to the size of the market because in a large group (say one that holds 80 percent of the outstanding stock) both buyers and sellers are likely to be adequately represented.

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07. September 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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