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Herd Behavior in Financial Markets

  
  Education
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HERD-ASROver the last twenty-five years, there has been a lot of interest in herd behavior in financial markets—that is, a trader’s decision to disregard her private information to follow the behavior of the crowd. A large theoretical literature has identified abstract mechanisms through which herding can arise, even in a world where people are fully rational. Until now, however, the empirical work on herding has been completely disconnected from this theoretical analysis; it simply looked for statistical evidence of trade clustering and, when that evidence was present, interpreted the clustering as herd behavior. However, since decision clustering may be the result of something other than herding—such as the common reaction to public announcements—the existing empirical literature cannot distinguish “spurious” herding from “true” herd behavior.

     In this post, we describe a novel approach to measuring herding in financial markets, which we employed in a recently published paper. We develop a theoretical model of herd behavior that, in contrast to the existing theoretical literature, can be brought to the data, and we show how to estimate it using financial markets transaction data. The estimation strategy allows us to distinguish “real” herding from “spurious herding,” or the simple clustering of trading behavior. Our approach allows researchers to gauge the importance of herding in a financial market and to assess the inefficiency in the process of price discovery that herding causes.

The Model
Let’s give an overview of the model that we brought to the data and try to explain why herding would arise. In the model, an asset is traded over many days; at the beginning of each day, an event may occur that changes the fundamental value of the asset. If an event occurs, some traders (informed traders) receive (private) information on the new asset value; although this information may be imprecise, these traders do know that something occurred in the market to alter the value of the asset. The other traders in the market trade for reasons not related to information, such as liquidity or hedging motives. If no event occurs, all traders only trade for non-informational reasons. (more…)

11 Biases That Affect Traders

  
  Education
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Overconfidence
As the name suggested, it is the irrational faith in one’s skills, methodology or beliefs. For example, you see a certain chart pattern and make a maximum leveraged trade, even though you understand that any chart pattern cannot predict market with certainty. Trading excessively after a winning streak also shows overconfidence.
Cognitive Dissonance
It means finding excuses for something which makes you ‘uncomfortable’. For example, jumping from one indicator to another when you face losing trades; or continuing to trade in stock even your trading methodology does not gives you a positive expectancy. 
Availability Bias
It means being biased to information which is readily and easily available. For example, people begin to trade using RSI without understanding the internal relative strength; that is, RSI is most talked about on forums so start using them without rationally researching it. Being affected from attractive advertisement or intelligent sounding articles (including this one!) without due diligence also signifies availability bias.
Self-Attribution Bias
It means giving yourself unwarranted praise for outcomes which may just be an outcome of chance. For example, people make money in a bull market through buy and hold and start begin to believe on their trading acumen rather than the market regime which favors their trading style. (more…)

THE BEST OF JESSE LIVERMORE

  
  Education
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On emotions: 

The unsuccessful investor is best friends with hope, and hope skips along life’s path hand in hand with greed when it comes to the stock market. Once a stock trade is entered, hope springs to life. It is human nature to be positive, to hope for the best. Hope is an important survival technique. But hope, like its stock market cousin’s ignorance, greed, and fear, distorts reason. See the stock market only deals in facts, in reality, in reason, and the stock market is never wrong. Traders are wrong. Like the spinning of a roulette wheel, the little black ball tells the final outcome, not greed, fear or hope. The result is objective and final, with no appeal.
I believe that uncontrolled basic emotions are the true and deadly enemy of the speculator; that hope, fear, and greed are always present, sitting on the edge of the psyche, waiting on the sidelines, waiting to jump into the action, plow into the game.
Fear keeps you from making as much money as you ought to.

On herd behavior:

I believe that the public wants to be led, to be instructed, to be told what to do. They want reassurance. They will always move en masse, a mob, a herd, a group, because people want the safety of human company. They are afraid to stand alone because they want to be safely included within the herd, not to be the lone calf standing on the desolate, dangerous, wolf-patrolled prairie of
contrary opinion.

On cash:

First, do not be invested in the market all the time. There are many times when I have been completely in cash, especially when I was unsure of the direction of the market and waiting for a confirmation of the next move….Second, it is the change in the major trend that hurts most speculators. (more…)

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