CHAPTER 8:

HERDING BEHAVIOR
IN FINANCIAL
MARKETS
 FINANCIAL MARKET
Financial markets refer broadly to any marketplace where the trading of
securities occurs, including the stock market, bond market, forex market,
and derivatives market, among others. Financial markets are vital to the
smooth operation of capitalist economies.
HERDING BEHAVIOR
 It refers to how individual decisions
are influenced by group behavior.
 A phenomenon where investors
follow what they perceive other
investors are doing, rather than
relying on their own analysis.
 Herding behavior at scale can create
asset bubbles or market crashes via
panic buying and panic selling.
 WHY HERDING BEHAVIOR OCCURS?

 TO FOLLOW THE CROWD

 DEFERENCE TO PROFESSIONAL
 NOT GETTING LEFT BEHIND –
EASIER TO GO WITH THE FLOW
 RATIONAL AND IRRATIONAL
HERDING
(DEVENOW AND WELCH, 1996)

RATIONAL HERDING IRRATIONAL HERDING

RATIONAL HERDING IS
INFORMATION-BASED;
RATIONAL INVESTORS WITH
SIMILAR STOCK
PREFERIENCES ADOPT THE
SAME RESPONSE TO SIMILAR
INFORMATION ABOUT
COMPANY CHARACTERISTICS
AND FUNDAMENTALS.
IRRATIONAL HERDING
OCCURS WHEN INVESTORS
WITH INSUFFICIENT
INFORMATION AND
INADEQUATE RISK
EVALUATION DISREGARD
THEIR PRIOR BELIEFS AND
BLINDLY FOLLOW OTHER
INVESTORS’ ACTIONS.
THREE FORMS OF RATIONAL HERDING
BEHAVIOR IN FINANCE MARKET

INFORMATION-BASED HERDING
It happens when everyone reacts the
same way to announced information.
THREE FORMS OF RATIONAL HERDING
BEHAVIOR IN FINANCE MARKET

REPUTATION-BASED HERDING
It is caused by a respected investor or
major trading house taking a specific
trading stance.
THREE FORMS OF RATIONAL HERDING
BEHAVIOR IN FINANCE MARKET
COMPENSATION-BASED HERDING
It occurs when certain conditions prompt large
institutional money managers to take profits, generally to
protect fund earnings before year-end reporting. These
behaviors create large volume in certain stocks or sectors
that are popular institutional portfolio investments,
prompting those watching to react quickly.
 HERD EFFECT IN FINANCIAL
MARKETS
A HERD EFFECT exists in the financial market when a group of
investors ignores their own information and instead only follows the
decisions of other investors.
Some studies treat this effect as an INTRADAY PHENOMENON,
which intuitively makes sense. Investors are much more likely to
imitate others than to interpret the information they receive when they
have little time to make investment decisions. In recent years, this
effect has been studied based on the information cascade model.
INFORMATION CASCADE MODEL
(THE SCHEME)
 HERDING AND BUBBLES

A bubble is an economic cycle that is characterized

by the rapid escalation of market value, particularly
in the price of assets. This fast inflation is followed
by a quick decrease in value, or a contraction, that is
sometimes referred to as a "crash" or a "bubble
burst."
 TULIPMANIA
Tulipmania is the story of the first major financial bubble, which
took place in the 17th century. Investors began to madly purchase
tulips, pushing their prices to unprecedented highs. The average
price of a single flower exceeded the annual income of a skilled
worker and cost more than some houses at the time. Tulips sold
for over 4000 florins, the currency of the Netherlands at the time.
As prices drastically collapsed over the course of a week, many
tulip holders instantly went bankrupt.
 DOTCOM BUBBLE
The dotcom bubble was a rapid rise in U.S. technology stock equity
valuations fueled by investments in Internet-based companies in the
late 1990s. The value of equity markets grew exponentially during the
dotcom bubble, with the Nasdaq rising from under 1,000 to more than
5,000 between 1995 and 2000. Equities entered a bear market after the
bubble burst in 2001. The Nasdaq, which rose five-fold between 1995
and 2000, saw an almost 77% drop, resulting in a loss of billions of
dollars. The bubble also caused several Internet companies to go bust.
5 STAGES OF ECONOMIC BUBBLE
STAGE 1: DISPLACEMENT
A displacement occurs when investors get enamored
by a new paradigm, such as an innovative new
technology or interest rates that are historically low.
 5 STAGES OF ECONOMIC BUBBLE
STAGE 2: BOOM
Prices rise slowly at first, following a displacement, but then gain
momentum as more and more participants enter the market, setting
the stage for the boom phase. During this phase, the asset in question
attracts widespread media coverage. Fear of missing out on what
could be a once-in-a-lifetime opportunity spurs more speculation,
drawing an increasing number of investors and traders into the fold.
 5 STAGES OF ECONOMIC BUBBLE
STAGE 3: EUPHORIA
During this phase, caution is thrown to the wind, as asset
prices skyrocket. Valuations reach extreme levels during this
phase as new valuation measures and metrics are touted to
justify the relentless rise, and the "greater fool" theory—the
idea that no matter how prices go, there will always be a
market of buyers willing to pay more—plays out everywhere.
 5 STAGES OF ECONOMIC BUBBLE
STAGE 4: PROFIT-TAKING
In this phase, the smart money—heeding the warning signs
that the bubble is about at its bursting point—starts selling
positions and taking profits. But estimating the exact time
when a bubble is due to collapse can be a difficult exercise
because, as economist John Maynard Keynes put it, "the
markets can stay irrational longer than you can stay solvent."
 5 STAGES OF ECONOMIC BUBBLE
STAGE 5: PANIC
It only takes a relatively minor event to prick a bubble, but once
it is pricked, the bubble cannot inflate again. In the panic stage,
asset prices reverse course and descend as rapidly as they had
ascended. Investors and speculators, faced with margin calls and
plunging values of their holdings, now want to liquidate at any
price. As supply overwhelms demand, asset prices slide sharply.