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This paper provides an overview of the recent theoretical and empirical research on herd behavior in financial markets. It looks at what precisely is meant by herding, the causes of herd behavior, the success of existing studies in identifying the phenomenon, and the effect that herding has on financial markets. [JEL GI, G2, F4]
"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
Charles Mackay (1841)
In the aftermath of several widespread financial crises, "herd" has again become a pejorative term in the financial lexicon. Investors and fund managers are portrayed as herds that charge into risky ventures without adequate information and appreciation of the risk-reward trade-offs and, at the first sign of trouble, flee to safer havens. Some observers express concern that herding by market participants exacerbates volatility, destabilizes markets, and increases the fragility of the financial system.I This raises questions about why it is surprising that profit-maximizing investors, increasingly with similar information sets, react similarly at more or less the same time? And is such behavior part of market discipline in relatively transparent markets, or is it due to other factors?
For an investor to imitate others, she must be aware of and be influenced by others' actions. Intuitively, an individual can be said to herd if she would have made an investment without knowing other investors' decisions, but does not make that investment when she finds that others have decided not to do so. Alternatively, she herds when knowledge that others are investing changes her decision from not investing to making the investment.
There are several reasons for a profit/utility-maximizing investor to be influenced into reversing a planned decision after observing others. First, others may know something about the return on the investment and their actions reveal this information. Second, and this is relevant only for money managers who invest on behalf of others, the incentives provided by the compensation scheme and terms of employment may be such that imitation is rewarded. A third reason for imitation is that individuals may have an intrinsic preference for conformity.2
When investors are influenced by others' decisions, they may herd on an...