29 December 2022 Thursday
What is herd behavior in markets?
The increase in international financial relations with the increasing globalization in recent years has necessitated a closer monitoring of the behavior of market participants. As seen in both the Covid-19 outbreak and other global crisis experiences, the burdens imposed on economies by unexpected negative developments in real and financial markets determine the direction of investors' future expectations. In those periods, how the decision mechanisms of market participants will be shaped and how these decisions will be reflected in the financial markets become important due to the increase in uncertainty and the decrease in market confidence.
The situation of increasing uncertainty in periods of crisis plays a critical role in determining potential changes in investors' behavior. In such periods, investors' concerns about the returns of their financial assets increase and there is a tendency to imitate the behavior of other market participants when making investment decisions. The preference of the investor to act in harmony with the decisions of other investors, rather than relying on their current knowledge of the financial asset, brings up the phenomenon of "herd behavior".
The fact that market participants move away from rationality as a result of the increase in uncertainty in the markets and the decrease in confidence, result in the risk of anomalies in the market. In other words, the herd behavior of individuals as a result of the irrational decisions taken because of the shocks in the economies leads to volatility in the prices of investment instruments. The increase in stock and cryptocurrency market returns, especially during the Covid-19 period, causes the herd behavior to intensify and poses a threat to the functioning of the price mechanism in the markets. Therefore, this tendency creates destabilization by triggering market vulnerabilities and establishes a ground for the emergence of speculative bubbles (Banerjee, 1992; Filip et al.,2015). Furthermore, given the ever-expanding nature of global markets, the possibility of herd behavior spreading rapidly to other investors is increasing.
There is still ongoing debate about analyzing investor behavior in the context of examining the determinants of market efficiency. However, studies on various financial assets in the literature have found that individuals do not always act rationally in their investment decisions, and as a result, they disrupt market resistance and lead to inefficiency. Therefore, herd behavior and other irrational behavior patterns need to be examined further in order to maintain the efficiency in the markets in a stable manner.
References:
Banerjee, A.V. (1992). A simple model of herd behavior. The Quarterly Journal of Economics, 107(3), 797–817.
Filip, A., Pochea, M. and Pece, A. (2015). The Herding Behaviour of Investors in the CEE Stock Markets. Procedia Economics and Finance, 32, 307-315.
