We study herd behavior in a laboratory financial market with financial market professionals. An important novelty of the experimental design is the use of a strategy-like method. This allows us to detect herd behavior directly by observing subjects’ decisions for all realizations of their private signal. In the paper, we compare two treatments: one in which the price adjusts to the order flow in such a way that herding should never occur, and one in which the presence of event uncertainty makes herding possible. In the first treatment, subjects herd seldom, in accordance with both the theory and previous experimental evidence on student subjects. A proportion of subjects, however, engage in contrarianism, something not accounted for by the theory. In the second treatment, the proportion of herding decisions increases, but not as much as the theory would suggest. Moreover, contrarianism disappears altogether. In both treatments, in contrast with what theory predicts, subjects sometimes prefer to abstain from trading, which affects the process of price discovery negatively.
In recent years, there has been much interest, both theoretical and empirical, in the extent to which trading in financial markets is characterized by herd behavior. Such an interest stems from the effects that herding may have both on financial markets’ stability and on the markets’ ability to achieve allocative and informational efficiency.
The theoretical literature has tried to identify the mechanisms that lead traders to herd (for surveys, see, e.g., Gale, 1996; Hirshleifer and Teoh, 2003; Chamley, 2004; Vives, 2008). The theoretical contributions have emphasized that, in financial markets, the fact that prices adjust to the order flow makes it more difficult for herding to arise than in other setups, such as those studied in the social learning literature, where there is no price mechanism. Nevertheless, it is possible that rational traders herd, because there are different sources of uncertainty in the market, for example.
To test herding models directly with data from actual financial markets is difficult. In order to test for herd behavior one needs to detect whether agents choose the same action independently of their private information. The problem for the empiricist is that there are no data on the private information available to the traders. As a result, it is difficult to determine whether traders make similar decisions because they disregard their own information and imitate other traders, or because they are reacting to the same piece of public information, for instance.
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Herd Behavior in Financial Markets: An Experiment with Financial Market Professionals
