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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 herding Developed by
Scharfstein and Stein (1990), Trueman (1994), and Graham (1999)

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)

Principal agent model

Information acquisition models

Brennan (1990) and Froot et al. (1992). Hirshleifer et al. (1994), Calvo and Mendoza (1997) Bikhchandani et al. (1992) Banerjee (1992). Welch (1992)

Informational cascades model

Vives (1996), Neeman and Orosel (1999), Smith and Srensen (1997, 1999), Gul and Lundholm (1995), Gale (1996), Zhang (1997), Avery and Zemsky (1995), Hirshleifer and Welch (1998). Pingle (1995),

Behavioral models

Shiller and Pound (1989), Topol (1991), Lux (1995)

Compensation-based herding.

Brennan (1993), & Roll (1992)


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


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.


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.

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.


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, agents 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.


i 1

i ,t

Rm,t )

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): U U L L

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 L D t . = 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

CSSDt 1 Dt 2 Dt t

Interpretation of Christie and Huang model

The 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 1 and 2 coefficients would indicate herd formation by market participants. Similarly significant positive coefficients 1 and 2 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

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.


| 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:

CSADt 1 Rm,t 2 R

2 m ,t

Where 2 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 Rm,t is included in the test equation to investigate the non linearity in market returns, presence of significantly negative coefficient 2 confirm the existence of herding behavior in equity markets.


For daily data, the coefficient 1 , is significant and positive but the nonlinear term 2 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, i,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

Following the Pied Piper: Do Individual Returns Herd around the Market? An examination of herd behavior in equity markets: An international perspective

Author and year

Christie and Huang(1996)

stock returns, portfolio returns, CSSD index, Returns, CSAD, Dummy variables


No evidence of herding

Chang et al (2000)


USA, Hong Kong, Japanese, South Korean and Taiwanese markets

Herding identified in developing countries, south Korea and Taiwan but not in developed countries herding exists in extreme market conditions

Herding in the Italian Stock Market: A Case of Behavioral Finance.

Caparrelli, DArcangelis and Cassuto (2004) Gleason, Mathurb, and Peterson (2004) Demirer and Kutan (2005)

CSSD,CSAD, returns



Analysis of intraday herding behavior among the sector ETFs Does herding behavior exist in Chinese stock markets? Do investors herd intraday in Australian equities? An Analysis of Cross-Country Herd Behavior in Stock Markets: A Regional Perspective


returns, CSSD,CSAD returns, dummy variables, CSSD, CSAD Stock


No herding during extreme market movements No herding



Henker et al (2006) Demirer et al. (2007)

CSSD,CSAD, returns,

Australia Africa, Asia, Western Europe, Central and Eastern Europe, Latin America and the Middle East China

No herding intraday Herding in Asian and Middle Eastern stocks markets No herding in other regions

S&P 500 index, MSCI world index and oil prices

Herding behavior in Chinese stock markets: An examination of A and B shares Herding behavior in extreme market conditions: the case of the Athens stock exchange Herding Behaviour in the Chinese and Indian stock markets An examination of herd behavior Mediterranean stock markets in four

Tan, Chiang, Mason and Nelling (2008) Caporale, Economou, and Philippas (2008) Lao and Singh

CSSD, Trading volumes, returns volatility, CSSD, CSAD, returns Market

Herding exist in both markets


Evidence of herding is strong


returns, Trading volumes, CSSD, CSAD. CSAD, market returns, trading volume, and return volatility

China and India

Herding exist in both markets but more prevalent in China Evidence of herding in Portuguese stock market. No herding for the Spanish, Italian stock markets and Greek stock market.

Economoua,Kostakis and Philippas (2010)


Greek, Italian, Portuguese and Spanish stock markets

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