Academic journal article IUP Journal of Applied Finance

Herding Behavior in an Emerging Stock Market: Empirical Evidence from India

Academic journal article IUP Journal of Applied Finance

Herding Behavior in an Emerging Stock Market: Empirical Evidence from India

Article excerpt

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The history of the stock market shows that most investors buy stocks in companies or mutual funds for presumably sound reasons but exit their holdings the moment the market turns against them. They sell when a bunch of complete strangers offer them less than what they had paid for their investment. Conversely, they pay high prices for stocks just because other people whom they do not know, are willing to pay such prices. The dotcom boom was a result of such thinking. In the stock market parlance, this is known as investing with the herd or herding behavior. It is a phenomenon in which less sophisticated investors imitate market gurus or seek advice from victorious investors with a mind setup that using their own information will incur less benefits and more cost. Banerjee (1992) viewed herding as everyone doing what everyone else was doing, even when their information suggested doing something different.

Herd behavior happens when all investors copy the opinions of others to modify their private beliefs. It is a response task complexity created by constraints of time, information or ability. According to Cote and Sanders (1997), various factors which may influence herding include concern over one's reputation, forecast ability, perceived credibility of the consensus forecast and the variance among the individual opinions comprising the consensus forecast. Theoretically, herd behavior has two types of views: rational and irrational. The rational view advocates that individuals may rationally herd others whom they believe to be better informed in comparison to the market. Rook (2006) believed that herding is rational and subconscious but linked to a human need for conformity. On the other hand, when an investor behaves like a lemming and foregoes rational analysis, it leads to irrational herd behavior. According to Christie and Huang (1995), herding is a tendency of investors who irrationally ignore their own analysis and information and conform to the market consensus, even if they do not agree with it. Investors do so because it reduces their uncertainty and fulfills their need to feel confident (Vaughan and Hogg, 2005). Both explanations of herding behavior highlight that investors do not follow their own beliefs and analysis, but follow the market consensus.

The herd behavior of the investors results in trading in the market in the same direction over a period of time, thereby destabilizing the market. It moves the securities away from their fundamental value as share prices do not reflect the investors' rational expectations of the shares and also their irrational decisions (Nofsinger and Sias, 1999; Chang et al., 2000; and Demirer et al,. 2007). Herding behavior has been linked to market inefficiency which cannot be explained by the rational asset pricing models. Thus, in the presence of herding behavior, all the theories based on the assumption of the efficient stock market will become invalid. On the other hand, it may result in low abnormal return due to biased earnings estimates and reduced risk perception.

Literature Review

Since the 1990s, researchers have devoted extensive efforts to investigate the level of herding behavior in various stock markets in developed as well as developing markets. The theoretical studies concentrated on the explanation of what might trigger herd behavior (Scharfstein and Stein, 1990; Devenow and Welch, 1996; and Bikchandani and Sharma, 2001), while the empirical studies focused on testing the effect that herding has on financial markets. One strand of the empirical literature shows weak or no evidence of herding over the markets (Lakonishok et al., 1991; Christie and Huang, 1995; Chang et al., 2000; Henker et al., 2006; Lin and Swanson, 2008; Fu and Lin, 2010; and Khoshsirat and Salari, 2011). On the other hand, several studies have examined the herding behavior in various stock markets and found the existence of high degree of herding (Nofsinger and Sias, 1999; Wermers, 1999; Hwang and Salmon, 2001; Batra, 2003; Caparrelli et al. …

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