HERD BEHAVIOUR

Is herd behaviour rational or irrational?

Is herd behaviour rational or irrational?

Herd behavior was exhibited in the late 1990s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not (at the time) have financially sound business models. The driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same thing.

A strong herd mentality can even affect financial professionals. The ultimate goal of a money manager is to follow an investment strategy to maximize a client's invested wealth. The problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fad pops up. For example, a wealthy client may have heard about an investment gimmick that's gaining notoriety and inquires about whether the money manager employs a similar "strategy".

In many cases, it's tempting for a money manager to follow the herd of investment professionals. After all, if the aforementioned gimmick pans out, his clients will be happy. If it doesn't, that money manager can justify his poor decision by pointing out just how many others were led astray.

In financial markets, what part of a trader's action is simply “following the crowd” or herding, and how much is based on the trader's own information? Herding has been shown to decrease the stability and efficiency of markets, hence the interest in these behaviours. Marco Cipriani, economist with the Asian Division, IMF Institute, and economics lecturer Antonio Guarino, University College London, studied herd behaviour in a laboratory setting involving financial market professionals.

Cipriani presented their jointly authored IMF working paper on herd behaviour in financial markets at a recent seminar organised by the Economic Society of Singapore, School of Economics, Singapore Management University, and the IMF - Singapore Regional Training Institute. Cipriani and Guarino compare two treatments. In one, price adjusts to the order flow so herding by rational agents should not occur. In the other case, event uncertainty makes rational herding possible. In the first treatment, little herding is observed. In the second, herding increases although not as much as the theory suggests.

Herding and Price Instability

There is interest in herding behaviour in financial markets because it may affect their stability and informational efficiency. Prior literature has shown that when prices adjust to order flow, it becomes more difficult for herding to take place than if there is no price mechanism. Even with a price mechanism, however, herding may still occur because of event uncertainty in the markets.

Empirical tests for herding are hindered by the difficulty of separating the various motives for a trader's behaviour. What part of a trader's action is simply “following the crowd” (herding) and how much is based on the trader's own information? To overcome this problem, researchers have tested for herding behaviour in a laboratory financial market. The subjects are given information about a ...