5.5 Investor Biases and Heuristics
5.5.9 Herding
There is a common conception that investors have a penchant to flock together, acting like a herd in their trading decisions. This kind of behaviour is usually associated with ‘irrational’
volatility in the market and threatens the stability of financial markets. The inclination to imitate other investors that cause to a group of investors to act in the same way is referred to as herding (Lemieux, 2004, Cipriani and Guarino, 2009). Novice investors are prone to herding and that behaviour influences the price of stocks; this behaviour however does not occur among professional investors (Cont and Bouchaud, 2000). Teh and De Bondt (1997) and Gutierrez and Kelley (2009) also argue that herding can significantly influence the variance of stock returns. On the other contrary, Lakonishok et al. (1991) and Agarwal et al. (2012) argue that even professional investors are also susceptible to herding with the objective of “window- dressing” their portfolio. In South Africa, Sarpong and Sibanda (2014) also found that even professional mutual fund managers exhibit herd behaviour.
According to former Reserve Bank chairman Ben Bernanke, but for the financial crisis, it is not clear whether house prices would have tumbled so far or swiftly since in 2006, house prices had flattened out without declining much initially. When the crisis surfaced, in August 2007, prices of housing were about only 4 percent lower than they were at the start of 2006. Had it not been the panic, the bubble in the housing market might have gradually deflated, as has been anticipated by Federal Reserve’s forecasters had anticipated (Bernanke, 2015). Figure 5.7 shows how the price of housing in 20 major cities in the United States declined only modestly from the beginning of 2006 till August 2007 when the financial crisis began. The decline accelerated throughout the period of the crisis but in May 2009, prices stabilized as the crisis abated and home prices rebounded in early 2012.
Page | 102 Figure 5.7: Home Prices Fell Sharply After the Financial Crisis
Source: Adopted from S&P/Case-Shiller 20-City Composite Home Price Index, Seasonally Adjusted, Cited in Bernanke (2015: 353)
Rational Herding
There has been an emerging literature on 'rational herding' in financial economics. models in rational herding are developed mainly on one or more of three phenomena namely, payoff externalities models, Principal-agent models and cascade models (Devenow and Welch, 1996).
The Payoff externalities models posit that payoffs to an agent taking a particular action rises in the number of other agents taking the same action for example, the rule of driving on the left side of the road. The principal-agent models posit that to gain or preserve reputation in times of imperfectly informed financial markets, managers may choose either to 'ride the herd' thereby proving quality, or 'hide in the herd' thereby avoiding evaluation. Cascades models also posit that later agents, infer information from the behaviour of prior agents and optimally choose to disregard their own information and act in similar manner (Devenow and Welch, 1996).
Payoff Externalities: Market Liquidity
In the 19th century, there were roughly 250 stock exchanges in the United States, today, one- tenth of this number remains. This decline may be due to payoff externalities (Devenow and Welch, 1996). With economies of scale or informed traders imposing an externality on
Page | 103 uninformed traders (Admati and Pfleiderer, 1988; Chowdhry and Nanda, 1991), informed and uninformed traders will both gain from transacting in more liquid markets or markets with more depth consequently forcing most traders to transacting in only one market (Devenow and Welch, 1996).
Payoff Externalities: Information Acquisition
Payoff externalities can also influence the decisions of agents on stocks for which they seek information. In some circumstances, agents find it worthy to pursue further information only when other agents do, thus herding on the acquisition of information or the lack thereof (Devenow and Welch, 1996; Han and Yang, 2013). Brennan (1990) and Hirshleifer et al.
(1994) argues that private information reflect in the price of stocks a period after it acquisition, however, this only occurs after a minimum number of investors have also acquired such information. As a Consequence of this, the expected profits from acquiring information is dependent on the assessment of the expected gains of other investors leading to two equilibria.
In one equilibrium, no investor purchases such information since the likelihood of information reflecting in the stock price is negligible and vice versa.
Principal-agent/Reputation Models: Investment Decisions
Principal-agent concerns can also lead to rational herding as the evaluation of managers is usually based on relative performance as opposed to absolute performance (Devenow and Welch, 1996). Pan et al., (2016) provided results from a number of tests to argue that CEO investment cycle, where investment increases over the period of a CEO’s tenure while disinvestment decreases causing “cyclical” firm growth in employment and assets. This is caused by agency problems and leads to rising investment quantity and declining investment quality as the CEO, over time wins more control of his board. Morck et al. (1989) also reported that top management dismissals are related to a firm performing poorly relative to its industry, as opposed to industry failures. Baker and Haugen, (2012) argue that portfolio managers may include certain stocks in their portfolio simply because they are easy to explain the inclusion of such stocks to their investment committees. Lütje and Menkhoff, (2003) also report that fund manager, particularly senior managers use rational herd behaviour as a means of adapting to incentives.
These herding models usually reveal that managers prefer to mimic the actions of each other, totally disregarding private information, in order to avoid being exposed to be of low-skill in line with Keynes' remark in the General Theory that "it is better for reputation to fail
Page | 104 conventionally than to succeed unconventionally". Because of this, even the managers who are better than the average prefer to follow the crowd. This works in favour of worse managers as the decision to herd turn out to be a better decision (Devenow and Welch, 1996).
Informational externalities: Cascades
The most common explanation of rational herding may be cascades, as described in Welch (1992) and Bikhchandani et al. (1992). When actions are publicly visible but not private information and there is a limit to the information of a private agent and actions possible, the basic cascade models may become applicable. The argument is that agents obtain relevant information by observing the previous decisions of other agents, to an extent where it becomes optimal and rational to completely disregard their private information. An investor for example, in possession of the most adverse private information can be motivated to make a purchase regardless if he witnessed three investors making a purchase previously, here, the information from three buys could outweigh the negative private information. Over time, there is very little additional new information to the cascade, investors simply mimic others based on the assumption that such large number of investors cannot be wrong. This however, may lead to erroneous decision on a large scale. Information cascades are usually very brittle, as investors’
actions may be based only on public observation and hearsay therefore, any new public information or a more accurate information can alter the behaviour, and the direction of the cascade (Devenow and Welch, 1996; Deng, 2016).