Literature Review on Herd Behaviour

The behavioural finance is based on the two fundamental blocks that are psychology and limits to arbitrage. These concepts assume in the real world arbitrage is accomplished by undertaking risk and cost under consideration. Henceforth, the misplacing in the stock market / financial market may remain unopposed (Demirer, Lee and Lien, 2015). In contrast EMH is the concept that relies to a great extent on the capability of arbitrageur to tackle and remove the miss pricing in stock markets. Psychology as the second building block takes in to consideration the motivations on how and why the investor to choose and on what information makes the financial decisions.

The literature analysis shows that stock prices are subjected to more volatility than expected. Henceforth raises concerns on the overall anniversary of stock market. The herding behaviour in the stock market comes under limelight due to serious financial crisis. It is widely believed by the authors that the herding behaviour is the main cause of wide spread financial crisis in the market. This literature explores the reasons and motivations of the investor to pursue herding (Chiang, Jiandong Li and Nelling, 2013).

Herd Behaviour In Financial Markets

The phenomenon of herding behaviour in stock market is experienced for both types of investors that are retail and institutional. The phenomenon for the small investor is that they get caught in the “game created trend”, as they possess limited information. The external sources of low quality information target small investor to create the game and formulate crowd’s similar actions in an unreasonable way (Messis and Zapranis, 2014). Management board is responsible for motivating herd mentality in institutional investors, this motivation is not develop a market neither achieve efficiency via price differentiation rather is driven to maintain and safeguard their own personal interests since their performance reviews evaluated using basic parameters (Chen, Yang and Lin, 2012).

Asgharian, Lindhe and Wengström, (2012) explain that herd behaviour can be divided in to three basic types namely

• Information based herding,
• Reputation based herding and
• Compensation based herding.

Information-based herding

Demirer, Lee and Lien, (2015) make the point that information based herding is a specific type of behaviour exhibited in stock exchange that is achieved by fraudulent or incomplete information. The concept is understandable via cascades, firms when choose to invest their cash in research and develop for a specific area or for example an analyst goes on to recommend a stock there is a potential that cascades of information are breakable (Cipriani and Guarino., 2014). Here an example will clarify the concept a sample of 100 investors is selected and they are gathering information to decide whether or not they should invest in the market. Every single invest is act on its own hence the analyst’s forecast for profitability is different. The assumption for example is taken that 80 out 100 investor choose not invest and remain choose otherwise. The 20 that choose to invest in the market creates a scenario that leads 80 non investing investors to reconsider their decision and ultimately many would choose to invest, this chain reaction will influence many other and in the end most would invest. This example explains that individuals are influenced by the actions of others.  

Reputation-based herding

Yang et al, (2015) while discussing herding behaviour in organizations also discusses the concpet of reputation based herding. They reveal that the inexperience managers not trusting their own forecasts and copying more professional and resourced managers while altering their assessment to meet the standards presented by them. This imitating process create reputation based herding in the stock market (Zhang, 2013).

Compensation-based herding

Compensation based herding can be explained by the phenomenon that managers are compensated in comparison to professionals in the field hence in order to maintain the compensation the need to mimic the professionals arises that initiates compensation based herding in the companies that operate in stock market (Linders, Dhaene and Schoutens, 2014).

Causes of Herd Behaviour

The origination of herd behaviour is due to psychological reasons and can be termed as rational or wise thinking. The psychologists believe that this behaviour depicted by managers arise from the very human nature. This nature of human leads them to exchange information among each other; the exchange directs others to follow the information (Chen, 2013). The exchange of information can take place in form of face-to-face discussion or when one observes choices that other make. The attributes of behaviour that impact on the investors can be defined as heuristics, mental accounting, overconfidence, representativeness and farming.

When an investor is suffering from the factors mentioned above tend to respond to respond slowly or neglect information when it is inconsistent these condition affect the decision and when the investors have limited time to decide hence urgency can lead to copying the actions of others. This behaviour is depicted because no one wants to act alone hence herding due to imitating the behaviour develops in stock market (Schmitt and Westerhoff, 2014).

The herding in stock market is of interest for both practitioners and economist. The herding concept attracts economist because they are interested in because it affects the stock prices as they impact on the investment decision. Herding in financial markets impacts on the risk characteristics and return on stocks after changes in the asset prices. On the other hand practitioners are interest in herding as investor can be targeted to create profitable opportunities. (Truong and Le., 2014)

Using the herding the practitioners can influence investors to drive the prices towards a higher price then its fundamental values. In the consequences of this the investors are required with more securities to reach the same level of diversification (Jurkatis, Kremer and Nautz., 2012).