Behavioral Finance in Herd Behavior

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Behavioral Finance and Herd behavior

National Taiwan University, department of Finance, Group 6, Oct 30, 2012.

BEHAVIORAL FINANCE AND HERD BEHAVIOR

INTRODUCTION
There are various types of irrational behaviors of investors, among which we are highly interested in why people tend to follow what others do rather than believe in his or her own judgment. The phenomenon is called herd behavior. Some investors claim, “We know there is herd mentality, so we need to be in the group.”

HYPOTHESIS : HERD BEHAVIOR1
Observing from the following examples , a tendency was unveiled that people would imitate the actions of a large group. It is sometimes a rather convenient way to deal with problems when faced with unimportant choices or when our brains are simply too lazy to activate System 2; however, in the following cases, people irrationally invested their hope and money, which obviously need to be dealt with rationality, into the markets they knew little about. We want to discuss about this irrational part of Herd Behavior. Below are three main reasons as hypothesis we think responsible for the irrationality: 1. The pressure of self-questioning. Human beings are social by nature and often make a choice in consideration of the acceptance of a group. If their analysis for markets is different from the public opinion , people would be confused and anxious. 2. The common rationale that the majority or the professional is unlikely to be wrong. Even if people are convinced that a particular analysis or action is incorrect or even irrational, they might still follow the herd and believe that the majority has some information that they don't. 3. People think they possess some private information not public shared. Nevertheless, they are still mimicking a little group's opinion without analysis from themselves. 1

Behavioral Finance and Herd behavior

EXAMPLE 1: The International Bubble/Dot-Com Bubble
< Onset of Dot-com Boom >2 Began from 1993, the World Wide Web’s commercial value was discovered by more and more people. Tons of money from venture capitalists and private investors flowed into internet-based stocks and other relative markets. The group of new internetbased companies was called the dot-coms.3 Although some of the dot-coms didn’t have a sound financial structure or business model, the deluge of blind money from worldwide speculators never stopped in the late 1990s. < What was the market thinking? > 1. During the booming, companies could foresee their stock price skyrocketing by simply adding an “e-“ at the beginning of their name or “.com” to the end. 2. In the year 1999, there were 457 IPOs, most of which were internet and technology related. 117 of them doubled in price on the first trading day. Compared with 2001, there were only 76 IPOs, and none of them doubled on the first day of trading. 3. The technology-heavy NASDAQ Composite index peaked at 5,048 in March 2000, reflecting the high point of the dot-com bubble.

< Burst of Bubble > The bubble burst during 2000-2001. The NASDAQ fell from the peak of 5,048 to the half, 2,524, in just few months in 2000 and kept dropping. Some profitable and well-performing companies lost large portion of its capital. For example, Cisco, whose stock declined by 86%.; however, most of the dot-coms were bad-managed and failed completely. Take the Pets.com for example : ● Pets.com (1998-2000) (a) Spent multimillion dollars for advertisement. Consequently, they didn’t work. (b) Undercharged the shipping costs to attract customers . As a result, it lost money on most of the items it sold. However, people still invested it for $82.5 million in an initial public offering . 2

Behavioral Finance and Herd behavior

< Hypothesis Behind the Blind Money > The reasons for the internet bubble4 were widely discussed. Some people thought it was a case of too much too fast. Companies didn’t know how to deal with millions of invested dollars and the expectation of becoming the next...
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