Problem Statement: Investors’ Herd in Stock Markets

Empirical evidence shows that “waves of irrational sentiment” (Schmeling, 2009, p.4) such investors’ herd may lead to a persistent and strong stock mispricing (Brown and Cliff, 2005). Investors, in fact, by herding around the market consensus form a systematic behavior pattern that pushes the value of the stocks away from their intrinsic value. Adding insult to injury even when investors do change their course of action and rationally absorb and react to the new market announcement, they do too slowly (i.e., under-reaction) with the result that market no longer reflects the real value of the asset.

The presence of herd behaviour in financial markets represents a violation of the axioms of rational agent and arbitrage pivotal in the EMH proposition.

Although it is reasonable to assume that herding is more an irrational decision-making strategy rather than rational response, the present dissertation will adopt the approach of Hirshleifer and Teoh (2003) which argue that, in fact, herding “is a combination of rational and irrational behavior among investors in financial markets” (p.47). Following this argumentation, herding behaviour will be analyzed from the perspective of market wide-herd which does not differentiate between rational and irrational manifestation in the financial market. Simply put, herding among investors arises when they “ignore the individual characteristic of the stock and instead follow the performance of the market” (Henker, Henker and Mitsios, 2006, p.197). Moreover, Christie and Huang (1995) have defined herd as “individual who suppress their own beliefs and base their investment decisions solely on the collective action of the market, even when they disagree with its prediction” (p.31). In other words, investors systematically and irrationally disregard their own investment information in favor to blindly conform their action to the market consensus.

The leading idea of this dissertation is that – especially in countries characterized by a collectivist society such as China – herd behaviour shed light on how investors’ form their (cognitive biased) stock price expectation. The scope of this dissertation is to empirically detect and test whether there is a significantly low dispersion of stock price return in Shanghai and Shenzhen Stock Exchange as a sign of investors’ conformity behavior to the market consensus (i.e., herding).