Herding Behaviour in the stock

markets
What is herding behavior?
 Banerjee (1992) define herding as “everybody doing
what everyone else is doing even when their private
information suggests doing something else”.
 Individuals who suppress their own beliefs and base
their investment decisions solely on the collective
actions of the market, even when they disagree with its
prediction (Christie and Hwang, 1995)
 Herding behavior is one of the behavioral phenomena
affecting the financial market stability and the market
ability to achieve allocative and informational
efficiency.
Views on herding
According to Devenow & Welch (1996) there
are two polar views on herding
Rational herding: based on externalities and
access to information or incentive issues may
distort the optimal decision making of an
investor.
Irrational herding: based on investor
psychology, where investors follow the
actions of others blindly by simply ignoring
rational analysis.
Types of herding
Two types of herding have been identified
in literature:
Herd towards particular stock and
Herd towards the market.
Consequences of Herding
In financial markets herding behavior can
distort the price of shares, other financial
assets such as currencies, because they are
traded above or below their true value.
Herding by market participants
exacerbates volatility, destabilizes
markets, and increases the fragility of the
financial system
This behavioral impact on stock prices
tends to affect the risk and return
characteristics of the stock and affect the
asset pricing mechanism
Portfolio diversification
Herding exaggerate the fickle nature of
stock markets
Empirical Evidence
The existence of herd behavior in speculative
markets has been documented by a certain
number of studies:
Scharfstein and Stein (1990) discuss evidence
of herding in the behavior of fund managers,
Grinblatt et al. (1995) report herding in mutual
fund behavior, and
Trueman (1994) and Welch (1996) show
evidence for herding in the forecasts made by
financial analysts
MODELS OF RATIONAL
HERDING
Models of herding
Principal agent model
Information acquisition models
Informational cascades model
Behavioral models
Compensation-based herding.
Developed by
Scharfstein and Stein (1990), Trueman
(1994), and Graham (1999)
Brennan (1990) and Froot et al. (1992).
Hirshleifer et al. (1994), Calvo
and Mendoza (1997)
Bikhchandani et al. (1992)
Banerjee (1992). Welch (1992)
Shiller and Pound (1989), Topol
(1991), Lux (1995)
Brennan (1993), & Roll (1992)
Used by
Zwiebel (1995), Maug and Naik (1995)
and Palley (1995), Stickel (1990,
1992, 1995), Olsen (1996),
Cote and Sanders (1999), de Bondt and
Forbes (1999), and Welch (1999).
Cote and Goodstein (1999)
Golec (1997)
Vives (1996), Neeman and Orosel
(1999), Smith and Sørensen
(1997, 1999), Gul and Lundholm
(1995), Gale (1996), Zhang
(1997), Avery and Zemsky
(1995), Hirshleifer and
Welch (1998).
Pingle (1995),
PRINCIPAL AGENT MODEL

The key characteristic of this type of

models is that relative performance
evaluation and reputational concerns of
managers or analysts cause principal-
agent problems
 In such a setting, agents will herd and
mimic the investment decisions or
earnings forecasts of other agents in order
to convey to their principals that they
possess superior skills
INFORMATION ACQUISITION
MODELS
This type of models focus on information
acquisition patterns of investors.
Herding arises when all investors choose
to study the same assets or sources of
information or when investors purchase
information only if many other investors
do.
INFORMATIONAL CASCADE
MODELS
The notion of informational cascades suggests
that the behavior of other individuals conveys
information to an observing individual. At a
certain point, this individual will disregard
his own information and follow the decisions
of others. Subsequent individuals will then
find this individual's action to be
uninformative, which puts them in the same
situation, causing them to ignore their own
information and engage in herding as well.
BEHAVIORAL HERDING
Investor psychology, interpersonal communication, or contagion of interest are the
sources of irrational decision-making.
Interpersonal communication
Investors did not seem to be systematic in their buying decisions and that both
institutional and individual investors' initial interest in a stock was stimulated by
other investors
Mimetic contagion
 Imitation is more likely when a decision is made for the first time, a change in the
decision-making environment occurs, and when the decision making environment
is competitive or challenging
Psychological factors
 Psychological factors are modeled as follows. Traders can either be optimistic or
pessimistic. Suppose that there is a high proportion of optimistic traders. Because
traders are non-sophisticated and susceptible to other traders' behavior, it is very
likely that the remaining pessimistic traders change their attitudes and become
optimistic as well. Herding is therefore characterized as contagion of sentiment.
COMPENSATION BASED HERDING
 Maug & Naik (1995) find that a risk averse
investors compensation increases with her own
performance and decreases in the performance of
a benchmark, because the compensation of agent
is an increasing function of the profit he earns
and a decreasing function of benchmark profits,
both the agent and benchmark investor make
decisions on imperfect private information about
stock returns. Therefore, agent’s portfolio choice
decision is followed by the action of benchmark
investor.
Table 1 – Empirical studies on institutional herding in stock markets
Christie and Huang (1995) model
In this study, Cross-sectional standard deviation (CSSD) is employed to measure the
equity return dispersion, the equation of CSSD is shown below.
N

 (R i ,t  R m ,t )
CSSD t  i 1

N 1
Where, N is the number of firms in the portfolio, Ri t is the individual stock return of firm
i at time t, Rm,t is the cross-sectional average stock of N returns in the portfolio at time
t.
 This study test herding by estimating the following empirical design proposed by
Christie & Huang (2005):
CSSD     D   D  
t 1
U
t
U
2
L
t
L
t
DtU
 Where, = 1, if the return on the aggregate market portfolio for the time period t lies
in the extreme upper tail of the returns distribution, and 0 otherwise
 . DtL
 = 1, if the return on the aggregate market portfolio for time period t lies in the
extreme lower tail of the returns distribution, and 0 otherwise
Interpretation of Christie and Huang
model
 The α coefficient describe the average level of dispersion of the
sample, include the area excluded by the dummy variables
 The dummy variables describe the difference in investor behavior
during extreme market movements from the period of relatively
normal market returns.
 The presence of negative and statistically significant β1 and β2
coefficients would indicate herd formation by market
participants.
 Similarly significant positive coefficients β1 and β2 establish the
prediction of rational asset pricing model.
 As per rational asset pricing model, the relationship between the
absolute value of the market return and equity return dispersion is
positive because investors obtain different information and have
different expectations about the market
Results
For daily, weekly and monthly data regression
results yield significantly positive coefficients for
all coefficients, so these results supports the
rational asset pricing models and absence of
herding.
The regression results for monthly data are
significantly positive for 1% criteria, whereas
insignificant for 5% criteria where data extreme
values lies at 1% and 5% of the upper and lower
tails of the distribution. It implies that affect of
herding behavior average out in long run.
 Chang, Cheng and Khorana model
In this study, Cross-sectional absolute deviation (CSAD) is employed to
measure the equity return dispersion, the equation of CSAD is shown
below. N
1
CSAD t 
N
| R
i 1
i ,t  Rm , t |

Where Rm,t is the average return of the equal-weighted market portfolio at

time t, which represents the market return, and, Ri,t is the individual stock
return of firm i at time t

An alternative methodology was proposed by Chang et al. (2000) to identify

herding. To examine the relationship between the absolute value of the
market return and equity return dispersion, the following regression is used:
CSAD     R
t 1 m ,t  R 2
2 m ,t  t

Where γ2 is the coefficient of Herding behavior if it comes as significantly

negative
Interpretation of Chang et al Model
 Herding behavior result in increase in correlation among asset returns,
and likely to decrease dispersion among asset returns, or increasing at
a decreasing rate with the market returns, so the relationship between
aggregate market returns and individual securities become non
linearly increasing or even decreasing (Chang et al, 2000)

 The relationship among CSAD and Rm,t indicates the presence of

herding, where Rm,t is the equally weighted average stock returns in
the KSE listed portfolio,

 where as Rm2 ,tis included in the test equation to investigate the non
linearity in market returns, presence of significantly negative
coefficient γ2 confirm the existence of herding behavior in equity
markets.
Results
For daily data, the coefficient g1 , is
significant and positive but the nonlinear
term g2 is significant and negative
confirming the presence of herding
because market dispersion is increasing at
decreasing rate.
Hwang and Salmon model

The market the proposed model for estimating

the degree of herding is given below,

Where, bi,t is the time-invariant systematic

risk measure of the security, i = 1, . . . ,N and t
= 1, . . . ,T .
Hmt is the measure of degree of herding, If Hmt
= 0, then no herding and Hmt =1 means perfect
herding.
 Table 2: Empirical Studies on Market Wide Herding in Stock
Markets
Title Author and year Variables Country Results
Following the Pied Piper: Do Individual Returns Christie and Huang(1996) stock returns, portfolio USA No evidence of herding
Herd around the Market? returns, CSSD

An examination of herd behavior in equity Chang et al (2000) Stock index, Returns, USA, Hong Kong, Japanese, Herding identified in developing
markets: An international perspective CSAD, Dummy South Korean and countries, south Korea and
variables Taiwanese markets Taiwan
but not in developed countries

Herding in the Italian Stock Market: A Case of Caparrelli, D’Arcangelis CSSD,CSAD, stock Italy herding exists in extreme market
Behavioral Finance. and Cassuto returns conditions
(2004)

Analysis of intraday herding behavior among Gleason, Mathurb, and Stock returns, USA No herding during extreme market
the sector ETFs Peterson (2004) CSSD,CSAD movements

Does herding behavior exist in Chinese stock Demirer and Kutan stock returns, dummy China No herding
markets? (2005) variables, CSSD,
CSAD

Do investors herd intraday in Australian equities? Henker et al (2006) CSSD,CSAD, Stock Australia No herding intraday
returns,

An Analysis of Cross-Country Herd Behavior in Demirer et al. (2007) S&P 500 index, MSCI Africa, Asia, Western Europe, Herding in Asian and Middle Eastern
Stock Markets: A Regional Perspective world index and Central and Eastern stocks markets
oil prices Europe, Latin No herding in other regions
America and the
Middle East

Herding behavior in Chinese stock markets: An Tan, Chiang, Mason and CSSD, Trading volumes, China Herding exist in both markets
examination of A and B shares Nelling (2008) returns volatility,

Herding behavior in extreme market conditions: Caporale, Economou, and CSSD, CSAD, Market Athens Evidence of herding is strong
the case of the Athens stock exchange Philippas (2008) returns

Herding Behaviour in the Chinese and Indian stock Lao and Singh Stock returns, Trading China and India Herding exist in both markets but
markets volumes, CSSD, more prevalent in China
CSAD.

An examination of herd behavior in four Economoua,Kostakis and CSSD, CSAD, market
Mediterranean stock markets Philippas (2010) returns, trading
volume, and
return volatility
Greek, Italian, Portuguese Evidence of herding in Portuguese
and Spanish stock stock market.
markets No herding for the Spanish, Italian
stock markets and Greek
stock market.
Thank you