Herding is a term that literally means acting or moving together as a group without any definite direction. It could apply to a group of animals, people, or even objects. In finance, the term is used to describe investors and/or fund managers who get into ventures that are risky without having sufficient information concerning the ventures then run away to safer markets at the first signal of trouble (Decamps and Lovo, 2000, p.1). Herding could apply to an investor who decides to trade his/her investments in markets that he/she has little information regarding the possible risks and on noticing danger they decide to flee to other market ventures. In other words, herding in financial markets is characterized by mutual imitation by investors, which makes them make similar moves in the stock market. As such, herding by market investors has been of great concern given the fact that it brings about several effects to the market. This paper is therefore an in-depth analysis of the effects of herding on stock markets.
Several factors could make an investor to practice herding. To begin with, most of the investors lack information concerning the stock market and they therefore imitate others in the market. As a result, they end up plunging their investment in ventures that are not doing well in the stock market, or risky ventures after which they decide to run away on noticing danger (Ottaviani and Sorenson, 2000, p. 696). Other investors end up because of having money managers to run their investments. In the event that they notice that, the money managers have made a wrong choice they flee and get to other market ventures.
Herding is a bad behavior that has several effects on the stock market. First, herding behavior destabilizes the market since the investors keep on moving from one market venture to another without giving the market ventures time to make use of the investment and grow (Rook, 2006, p. 78). The instability of the stock market is a big threat to the economy because it is one of the key players of the economy. Secondly, financial observers have also indicated that herding behavior increases the degree of market volatility. This is to mean that the market becomes even more unpredictable. This could have the effect of having investor withdraw their shares from the stock market while preventing new investors from entering the market. In the end, the stock market is left weaker hence being a threat to the economy of the nation. Herding has also been noted to make the financial system of a nation more fragile. This is because of the unpredictability of the investors that comes about because of the herding behavior. Herding behavior by market investors is also responsible for mispricing of securities (Economou, Kostakis, and Philippas, 2010, p.2). This is because the decisions made regarding the investment choices are no longer rational but rather through the opinion of the returns and risks expected on the investment. When this happens, the movement of stock prices is affected thus leading to huge losses on some investment companies and individuals.
From the above discussion, it is clear that the herding behavior significantly affects the stock market. Since the stock market is a key player in the economy of every nation, it is important that investors be advised on the effects that they could bring about due to their herding behavior. Nevertheless, the results obtained from herding behavior have proved useful in the development of stock behavior models that provide information to the policymakers regarding the same (Economou, Kostakis, and Philippas, 2010, p.2).
Decamps, J., and Lovo, S. (2000). Risk Aversion and Herd Behavior in Financial Markets. Web.
Economou, F., Kostakis, A., and Philippas, N. (2010). An examination of herd behavior in four Mediterranean stock markets. Web.
Ottaviani, M., and Sorenson, P. (2000). Herd Behavior and Investment: Comment. American Economic Review, 90(3), 695–704.
Rook, L. (2006). An Economic Psychological Approach to Herd Behavior. Journal of Economic Issues, 40(1), 75–95.