Stock Market Bubble and Herding

Topics: Subprime mortgage crisis, Stock market bubble, Herd behavior Pages: 9 (3009 words) Published: January 7, 2011
Herding is an everyday phenomenon from personal to financial contexts. The focus of this paper is to explore the theory of herding, namely Compensation Based Herding (CBH) and its effect on financial markets. The report aims to explain herding, assess the advantages and disadvantages of CBH incorporating the 2008 financial crisis, and explore the possibility that CBH may have no effect on the financial markets. Herding occurs when investors imitate each other and create a bandwagon effect. There are three general reasons why herding exists in financial markets. Firstly it is due to uncertainty, where if investors are unsure of the markets, they will simply mimic each other’s actions. Secondly, agents are compensated in relation to the market; hence, they are risking potential pay-outs by not “herding”. Thirdly, agents risk losing their jobs if they incorrectly predict the market and as a result following the market gives them a sense of security. Herding is a double-edged sword leading to both positive and negative effects. From one angle, it can be destabilizing to the market as discussed in Scharfstein and Stein (1990), as stock prices inflate in the short run but ultimately plunge (also known as a bubble), effectively creating a volatile market. On the other hand, herding also has positive effects on the financial market. If funds purchase stocks in a stabilizing manner, it can lead to gradual increase in stock price (Hirshleifer et al., 1994). This is positive for the stock market, provided that it is not a case of a potential bubble. Herding can also be positive to the economy in the case of good news. For example, after the governments began to help after the recent 2008 credit crisis through quantitative easing, it was the herd mentality, which resulted in a rally in the stock markets. Herding can be advantageous for the economy if it occurs together with intervention in both the short term and long term (Persaud, 2000). Without intervention, herding can lead to systematic risks as seen in the bubble in the 1997 Asian Financial Crisis. It is important to establish a clear definition of CBH. CBH occurs if an investment manager’s compensation is dependent on their performance, in comparison to that of other managers. As a result, the manager will herd in order to minimise the differences in performances and maximise personal compensation. Nonetheless, CBH is a complex topic for the realization that it has taken place is very difficult to distinguish. Evidence of CBH is underlined by Maug and Naik (1996), who observed a risk adverse investor whose compensation increased as a result of his own performance but fell in the performance of the benchmark investor. It was assumed that both investors had imperfect and private information about stock returns, the benchmark investor made the initial investment decisions and the second investor followed in accordance. The agent has the incentive to emulate the benchmark, especially as his optimal investment portfolio moves closer to the benchmark. Generally, if an investor underperforms in comparison to the benchmark, his compensation will decrease. As a result the investor will skew his investments towards the benchmark portfolio as opposed to if he was trading independently. Thus it is optimal for the employer of the agent to write such a relative performance contract when a moral hazard exists or when adverse selection is likely. Any contract that maximises a weighted sum of the principle and agent’s utility will also link the agent’s compensation to the benchmark. This is referred to as the herding constraint efficient due to the assumption of a single risky asset. Admati and Pfleiderer (1997) analysed a multiple risky asset model of a portfolio management whereby the agent investor has private information about stock returns. They found that the commonly observed compensation contracts for the agent relative to the benchmark were inefficient, ineffective against moral...

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