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Impact of Herd Mentality on Investment Decisions

Capital markets of an economy are a significant and indispensible source of investment and financing activities for corporate and other investors. Most of the financial assets are traded in these markets and they serve as the backbone of economic development. Such markets if engulfed in cognitive biases and psychological errors will result in misvaluations, excessive volatility and panic trading, thereby resulting in not just loss of capital from global sources, but also increased cost of capital for seekers of funds within the economy. It is therefore, imperative to understand these biases and the corrective actions necessary to reduce their effect. One of the major behavioural patterns observed among investors is herding.

Impact of Herd Mentality on Investment Decisions

Impact of Herd Mentality on Investment Decisions

Standard financial theories are rooted in the assumptions of rationality and profit maximisation that are based on the premise of efficient markets. These theories assume that investors are guided by fundamentals and asset prices discount all available information at all points in time. However, the financial market anomalies have shown that mean variance portfolio allocation is not always the case and limits to arbitrage exist and markets remain inefficient for longer than suggested periods of time. Thus, a new framework of behavioural finance is required to explain the phenomenon where conventional finance theories fail. Behavioural patterns influence investment decisions and result in sub optimal outcomes. The scope of behavioural finance focuses on the role and impact of psychology on the investment decisions.

In the past decade, this study has received a major impetus as it is important to understand the role of cognitive biases and why people make irrational investment choices. Among the many, one social bias is herd behaviour that leads to imitation and collective actions while making investments. Herding occurs when group actions are thought to carry better and more useful information than an individual. Financial literature argues that local group interactions in the absence of a central control mechanism triggers the pattern and although research asserts that it moves the asset prices closer to the fundamental value, yet continued periods of imitation disregarding the real value can lead to bubbles and market inefficiency.

Herd phenomenon is demonstrated at two levels- micro or investor category where money managers and fund managers herd due to reputational concerns or aggregate level with respect to the market returns which over a period of time can lead to the financial environment of high asset correlations. Although the study of heuristics and herd pattern specifically is exciting, it has some inherent risks like unethical applications in research. Despite this the scope of the field continues to grow and is a gold standard providing compelling evidence in explaining the anomalies especially for India which is at a turning point and remains an attractive investment market for retail and institutional investors and is vulnerable to psychological biases due to its emerging character.

Emerging financial markets are characterised by limited retail investor participation, information asymmetry and weak disclosure mechanisms, to name a few, that augment volatility in the returns and make them fragile and vulnerable. These features have the potential to induce systematic errors and psychological biases that result in mispricing and misallocation of resources in the economy. Numerous studies have proved that investors are normal and not rational and while making investment decisions. The Institute of chartered accountant of India release ICAI Exam Form. These psychological biases guide the process, sometimes to the extent of making the financial environment susceptible to major events. In extreme cases, these behavioural patterns have the capacity to even cause financial crisis.

According to Richard Thaler, the Nobel Prize winner of Economics, human beings are real and lack self-control and driven by social preferences and sentiments. Their emotions affect the investment decisions too and rational asset pricing models like CAPM and APT do not always hold valid making the standard finance theories questionable. This observation is further reinforced by studies that suggests that the existence of a disparity between assumptions of financial theories and how investors actually behave. These theories assume that a rational investor performs risk-return trade-off while making an investment decision and profitable payoff is the driving force behind any investment.

However, the recent financial market busts, for instance subprime crisis and Eurozone crisis demonstrate otherwise, that market participants and investors do not design portfolios according to the mean variance theory, rather through behavioural approach and expected returns are not just a function of beta, but something additional as well. When faced with complex situations that demand substantial time and effort, investors have difficulty in devising rational strategies and approaches and they tend to follow a sub-optimal path of choice and create bias in decision making. The investment cycle is full of psychological pitfalls and biases like overconfidence, herding, self attribution, loss aversion, disposition, framing and mental accounting to name a few. Investors rely on these heuristics- mental shortcuts and fall prey to cognitive biases and emotional predispositions. The interdisciplinary field of behaviour finance examines these biases and the effect on financial markets by taking insights from psychology and human behaviour and incorporating them to investment decision making to find answers to why investors behave the way they do

What is herd behaviour?

As teenagers we have experienced doing something that was suddenly cool or because everyone else was doing itknown or even unknown. People have a tendency to mimic the actions of others in the group that may not always be due to rational reasons. A number of motivating factors like, cost of information acquisition, intrinsic preference for social conformity, reputational concerns, compensation schemes and incentives can make the process of analysis challenging and complex resulting in investors relying on collective behaviour. If you want to know your bank balance at home then follow HDFC Balance Enquiry guide and know your balance by sms. Herd behaviour has been extensively studied in various disciplines like sociology, psychology, zoology, biology and also economics.

In especially economics and finance, herding is the phenomenon when investors follow the crowd and take investment decisions that might not be in accordance with their private information. Hence, there is an obvious tendency to imitate others that leads to a collective behaviour of buying or selling the stocks or assets in large numbers. Herd behaviour starts when the investor decides to make an investment based on private information, but do not do so, after learning that others are not investing or vice-versa.

Spurious and Intentional Herding:

Herding can be categorised as spurious and intentional, where the former leads to an efficient outcome as investors react similarly to the available public information whereas the latter leads to the ‘lemming’ like behaviour and in extreme cases excessive buying or selling, thus impacting the asset prices.

Such patterns over a continued period of time lead to bubbles as it is not in tandem with the efficient market hypothesis. A primary reason for a utility maximising investor to ignore private information and herd may be based upon the fact that group knows more and possesses better information than an individual or probably for social conformity and to be ‘one among the boys’. After all it is better to fail conventionally rather than succeed unconventionally. Money managers and portfolio managers may display the tendency to herd due to reputational reasons or sometimes their compensation and incentives schemes are such that imitation is rewarded and they follow the bigger fund managers only to confirm to the ‘big boys’ choices. In addition, if a fund manager is not confident of his investment selection and his ability to pick the right stocks, then herding prevents the fog as the manager is in-line with others in the market.

At the aggregate market level, herd behaviour may be exasperated during periods of market asymmetry for instance, high volatility or extreme movements making the markets fragile and vulnerable. Such periods cause clustering of the assets around the market and the dispersion between the individual asset return from the market return decreases. The research claims that the periods of extreme market movements and crisis provide a fertile ground to observe herding, although such phases prove to be corrective times as investors focus on fundamentals rather than fads. The prevalence of herd pattern in the financial market shows that the system is fragile and exposed to systematic risks. Candidates can take RSCIT Online Test and test there preparation for next RSCIT Online Exam It provides the warning to strengthen the information disclosure mechanism and regulations governing financial literacy and education.

Conclusion

This article only touches the tip of the iceberg on the theme of behavioural bias of herding and its implications for financial market and investors. Although the regulators have taken proactive measures by installing mechanisms and systems to mitigate the risk and minimise the aberrations caused in the financial market due to these behavioural biases, more preventive measures for instance, initiatives focussing on individual, peer and social learning of investors, rationalising the transaction costs, introducing diverse financial products, better trading methods of executing preprogrammed trading instructions such as algorithm trading that uses high frequency trade mechanics in wide variety of situations like arbitrage or trend trading need to be introduced. Also, an emergent technology of machine learning and the use of artificial intelligence can help in developing programs that will be self improving through deep learning. Such technologies can help in faster order executions at lesser costs.

Additionally, developing markets like other financial instruments, bonds and interest rate futures, that currently do not witness active participation will aid in improving the market efficiency. Further, financial markets should be made more inclusive by increasing the proportion of retail investor participation which currently stands at a mere 2.5% for the Indian equity market. This will ensure increased liquidity and better price discovery. Increased financial education and investor literacy programs should be developed and made available to the investors across categories to enable them to make informed decisions. Such programs will provide the market long term benefits and enable the investors to differentiate between rumours and true news and prevent them from making poor financial decisions. These programs also provide the benefit of greater investor confidence and act as a catalyst for higher participation in the securities markets, thereby improving liquidity and volumes.

Further the regulator should ensure that the investors are aware of their rights and responsibilities to make the markets more efficient. For academicians, the subject of herding offers a lucrative ground for more impactful research as the aspect of psychology in finance is unexplored at various levels and experimental studies in this area are the need of the hour. Such initiatives towards creating a more transparent market will generate more incentives to invest in the Indian financial markets.

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