What causes herd behavior

Herd behavior in financial markets





2.1 Assumptions of the neoclassical capital market theory
2.2 The homo oeconomicus
2.3 The theory of efficient markets

3.1 Origin, definition and goals
3.2 Behavioral Anomalies

4.1 Definition and characteristics of herd behavior
4.2 Causes and triggers of herd behavior
4.2.1 The information cascade model
4.2.2 The reputation model
4.3 The Keynes Beauty Contest as a model for herd behavior

5.1 Price bubbles and contagion effects
5.2 Application examples
5.2.1 Financial crisis from 2007
5.2.2 Bank Run



A.1: Modifications of the information cascade model
A.2: Experimental work on information cascades
A.3: The Beauty Contest as a number game - game theory representation
A.4: The number game in business newspapers



Illustration 1: Levels of market efficiency

Figure 2: Anomalies in human behavior

Figure 3: Ranking of the banks

Figure 4: Evaluation matrix

Figure 5: Game theory representation of a bank run

Figure 6: The physical setup

Figure 7: Elimination of dominant strategies

Figure 8: Iterated best reply model

Figure 9: Results of the number picking games


Figure not included in this excerpt


"I can calculate the orbit of the stars in centimeters and seconds,

but not where a crazy crowd can drive a stock market price. " (Sir Isaac Newton, quoted in: Schulz-Hardt et al., 2007, p.210)

Generations of scientists have always tried to predict how prices will develop in the future, but mostly have to acknowledge that the stock market is not only influenced by supply and demand, but also to a large extent by people's behavior. The fact that prices are sometimes subject to fluctuations that are hardly comprehensible from an economic point of view prompted the well-known stock exchange and financial expert André Kostolany to make the statement: “The role of psychology in the stock market cannot be overestimated. In the short and medium term, it makes up 90 percent - on the stock exchange and in the economy " (Kostolany, 1997, p.12).

The models of capital market theory are increasingly no longer regarded as meaningful due to their inadequate explanatory and prognostic content - the assumptions of a perfectly functioning capital market are now being called into question in many ways. In recent decades, more and more studies have emerged suggesting the existence of anomalies that cannot be explained by the existence of information efficiency in the markets. Strong price fluctuations due to mass psychological phenomena underscore the hypothesis that people are generally not like the one described by the neoclassical theory homo oeconomicus rather that the behavior of investors is influenced by feelings such as fear, greed, envy or euphoria. As part of the relatively young research direction Behavioral Finance these observations and considerations are systematized. As psychological aspects influence the analysis of the financial and capital markets, this theory contributes significantly to a better understanding of the markets (cf. Kitzmann, 2009, p.16).

One observation of behavioral finance is that financial markets are shaped by herd behavior. This financial market phenomenon is metaphorically often associated with lemmings who blindly follow one another and ultimately fall together into the abyss. Such behavior mostly occurs in situations of uncertainty, as people fear that their own assessments will be wrong. Such a mass phenomenon can be observed not only in daily life, such as in the theater, where one spectator starts to clap and the others join in, but also in the financial markets (see Ackstaller, 2005, p.15). Recent events such as the financial crisis from 2007 onwards have shown the consequences of driving prices to fundamentally unjustified heights, which in turn leads to the bursting of a speculative bubble and even global economic crises. Various studies suggest that these developments are favored by herd behavior in the financial markets. However, herd behavior is not necessarily an expression of irrationality, but can often be traced back to an individually rational behavior of the market players.

Even if the main focus of this work is on herd behavior, it still seems central to give a brief overview of the neoclassical capital market theory as well as the behavioral finance theory, so that a concrete classification of the herd behavior in the financial theory can take place. Accordingly, the work begins with a presentation of the neoclassical capital market theory, which is mainly characterized by the assumption of rationally acting actors and the theory of efficient markets. In the third chapter of the paper, the theoretical foundations of behavioral finance theory are presented, starting with the origin and definition, up to its goals and the anomalies of human behavior observed through them. In particular, it should be emphasized that the assumptions of behavioral finance theory are strictly delimited from capital market theory by postulating that emotions have a major influence on the capital market. The fourth chapter first deals with the fundamentals and characteristics of herd behavior. Then the central causes and triggers for this phenomenon are worked out. How herd behavior can occur and what effects it has on the financial markets should be the focus of this work. The fifth chapter accordingly represents the main part of the work. First, price bubbles and contagion effects are listed as the primary effects of herd behavior on the financial markets. This is then elaborated on using two application examples - the financial crisis from 2007 and the Bank Run. It is important to find out whether herd behavior must actually be viewed as a trigger for financial market crises. The last part of the work deals with measures that can contribute to the abolition of herd behavior. A short discussion and further considerations on the subject are presented here. In addition, considerations are made on the empirical evidence of herd behavior. The work ends with a conclusion in which a summary of the central results is drawn.


"Even after three decades of research and literally thousands of journal articles, economists have not yet reached a consensus about whether markets - particularly financial markets - are efficient or not." (Lo, MacKinlay, 2002, p.6)

2.1 Assumptions of the neoclassical capital market theory

In science, the neoclassical capital market theory is considered to be one of the most important approaches to assessing stock prices in the financial markets. It owes this great importance in particular to its consistency and simplicity (cf. Bies, 2011, p.10). Ideally, it assumes perfect and complete markets. As a result, it is assumed that all market participants not only use the same decision-making models, but also have the same, complete level of information at their disposal. This means that you have all the data relevant to a decision and can process new information immediately. Apart from that, every market participant shows the same rational behavior and accordingly has homogeneous expectations. In addition, they are able to carry out all transactions free of charge (see Kirchgässner, 2008, p.66). Advocate of Efficiency market hypothesis[1] argue , that irrational deviations from the fundamental value are always uncorrelated or are based on a coincidence and therefore cancel each other out. For example, a mispriced market can result from arbitrage[2] be brought back into equilibrium (see Hott, 2004b, p.10; Klug et al., 2009, p.29). Consequently, the neoclassical capital market theory assumes a perfect market in which there is complete competition. It mainly follows two models: on the one hand that of a rational investor, the so-called homo oeconomicus, and on the other hand the model of efficient markets (cf. Scheufele, Haas, 2008, p.25). In the further course of this chapter, only these two assumptions will be explained in more detail in order to be able to better differentiate the behavioral finance theory from the capital market theory. Accordingly, a more concrete presentation of the neoclassical capital market theory and the associated capital market models are not given at this point.

2.2 The homo oeconomicus

The basis of traditional capital market theory is the homo oeconomicus image of man - an economic behavior model that characterizes man as an individual oriented towards self-interest. Eduard Spranger describes a homo oeconomicus as follows: “The economic man in the most general sense is the one who puts the utility value first in all life relationships. For him everything becomes a means of sustaining life, the natural struggle for existence and a pleasant way of life " (Spranger, 1950, p.148). Accordingly, he is the ideal image of an economically rational acting and thinking individual who strives to maximize his benefit under the assumptions of efficiency, economic efficiency and functional rationality and also has complete and undistorted information (cf. von Nell, 2006, p.3) . However, every decision-making situation, especially in financial markets, is associated with a certain degree of uncertainty. The homo oeconomicus therefore has to make his decisions under uncertainty and can therefore often only assess their consequences with difficulty. Because of this, he feels compelled to consider probabilities in his decisions. Probabilities can be taken into account, for example, with the help of the expected value. For a rationally thinking person it is advantageous to choose the alternative that has the highest expected value and therefore the highest expected benefit. Furthermore, the homo oeconomicus does not have any emotions, that is, he does not allow himself to be guided by joy, desires, greed, fear and panic etc. (cf. Goldberg, von Nitzsch, 2004, p.38f and p.44).

However, the model concept of the homo oeconomicus is heavily criticized: Many studies show that market participants do not always act completely rationally, let alone are able to grasp all relevant information and process it correctly. The overvaluation of stocks or the creation of speculative bubbles cannot be satisfactorily explained on the basis of these assumptions. As a result, the image of the rationally acting and thinking market player is increasingly being called into question, since this model does not properly reflect reality (see Ranzau, 2010; Goldberg, von Nitzsch, 2004, p.47).

2.3 The theory of efficient markets

The theory of efficient markets, by the concept of which the financial and capital markets are strongly influenced, is based on the random walk hypothesis[3]. The efficiency market hypothesis assumes that all available information is exactly reflected in the price of a good, so that there is no room for mood, let alone herd behavior in the market (cf. Weber, Behavioral Finance Group, 1999). The American economist Eugene Fama is considered to be the founder of the efficiency market hypothesis, who defines an efficient market as follows: "A market in which prices always fully reflect available information is called efficient" (Fama, 1970, p.383). He further specifies: "In an efficient market, on the average, competition will cause the full effects of new information on intrinsic values ​​to be reflected‘ instantaneously ’in actual prices" (Fama, 1970, p.383). Fama takes three levels of market efficiency, whereby the distinguishing feature is the respective definition of the term “available information” (cf. Fama, 1970, p.383). As can be seen from the following graphic, the weaker form is enclosed by the stronger form.

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Figure 1: Levels of market efficiency (own illustration based on: Steiner, Bruns, 2007, p. 40).

The weak-form efficiency only contains information about past prices. The current market price reflects the information from the historical price developments at all times. Thus, by means of the technical analysis[4]which evaluates past price movements, no excess returns are achieved (see Rummer, 2006, p.19). This does not mean that positive returns cannot be achieved on a market; rather, these cannot be higher than the profit that can generally be expected on the capital market for a risk taken. If there is poor information efficiency in a market, it is possible to generate profits simply by analyzing publicly available information. The semi-strict form of market efficiency ("semi-strong-form efficiency") implies that, in addition to the past data, all publicly available information that is freely accessible to all market participants is included in the current price (cf. Stöttner, 1989, p .76). Therefore, there are neither undervalued nor overvalued securities. New information is fully and immediately integrated into the prices (cf. Kaiser, 2007, p.72). With the help of fundamental analysis[5] consequently, no excess returns can be achieved. In the semi-strict form, these can only be achieved by taking advantage of inside information. If, on the other hand, a market is efficient in the strict sense (“strong-form efficiency”), all information, i.e. past, publicly available and even insider information that is not freely accessible, is immediately processed in the current prices. As a result, it is assumed that no information exists that is suitable for generating excess returns, so that not even insiders have the opportunity to take advantage of their information advantage or to forecast price developments (see Schredelseker, 2002, p.418).

Regardless of the level of information efficiency, it is assumed that shares always correspond to their intrinsic value and that price changes can therefore only occur as a result of new information. For the market analyst, this means that he must assume that all the knowledge that can be gained through his analysis is already known to all other market participants. Provided that there are rational investors, the market will always behave in the same way. Therefore, the market price reflects all available information at any point in time, which makes it impossible to gain advantages over other market participants through an information advantage over other market participants (cf. Stöttner, 1989, p.72). In summary, it can be said that investors do not get an information advantage from the stock market data of securities that would enable them to achieve a return that is above the market average (cf. Montassér, 2003, p.2). The services of financial analysts, portfolio managers and investment advisors are primarily used because clients trust them to process information better than they do themselves. However, if all information is already included in the prices, the expected return for investors is completely independent of their level of information (see Schredelseker, 2002, p.420). Schredelseker states: "Whether an uninformed schoolboy or an experienced investment banker invests in a particular information-efficient market, the result, measured in terms of returns, will on average be the same" (Schredelseker, 2002, p.420) . He finally comes to the result: "In an information-efficient market there is no longer any space left free for prophets" (Schredelseker, 2002, p.421).

The price developments on the financial markets immediately raise the question of whether the markets are really efficient, since prices are exposed to strong fluctuations for no apparent fundamental reason (cf. Hott, 2004a, p.47). In this context, Thomas Lux comes to the conclusion: "From empirical side, one of the most discussed facts that gives rise to doubts in overall efficiency of stock markets is the finding that stock prices exhibit more volatility than fundamentals or expected returns do" (Lux, 1995, p.881). In addition, under the model assumptions of market efficiency, there is no room for psychology or feelings, nor for crash and euphoria scenarios, which, as has only recently been shown, occur in reality and cannot be justified in the context of efficient markets.The theory does not seem to be able to explain the functioning of the market system, which is not only the main problem of the efficiency market hypothesis, but also of the entire neoclassical capital market theory (see Jünemann, 1997, p.6; Schäfer, Vater, 2002, p.740 ).


"People in standard finance are rational. People in behavioral finance are normal. " (Meir Statman, 1995)

3.1 Origin, definition and goals

The neoclassical capital market theory is unable to realistically map events on the financial markets, let alone predict them. The model concept of homo oeconomicus and the theory of efficient markets represent a suitable and common framework for financial market models, but not only the recent financial market crisis has shown that the models of the neoclassical capital market theory can often only offer a limited explanatory value, since the behavior of financial market participants cannot or can only be inadequately explained using classical capital market theory (cf. Deutsche Bundesbank, 2011, p.47). Financial market participants do not, as assumed by capital market theory, have homogeneous expectations. Instead, they tend to have heterogeneous expectations. Furthermore, in reality, the capital markets are neither perfect nor complete, which means that information is asymmetrically distributed[6] of the individual market players. From this knowledge it results that in the last decades a new research direction, the Behavioral Economics (Behavioral economics), the old theories are increasingly supplemented by psychological findings. Behavioral Economics deals with irrational behavior of people in economic situations. One of the most important areas of this teaching is Behavioral Financewhich deals with the irrational behavior of market participants in financial and capital markets as well as exploring the causes of market anomalies (cf. Elger, Schwarz, 2009, p.213). It starts at the interface between psychology and economics and began in the 1970s[7] (see Goldberg, von Nitzsch, 2004, p.13). Robert Shiller's remarks from 1981 can be viewed as the starting point for this relatively new branch of research, which shows that share prices fluctuate more than is predicted by the efficiency market hypothesis (cf. Shleifer, 2000, p.16f). The behavioral finance theory assumes that market participants can only behave rationally to a limited extent due to psychological, mental and neural restrictions (cf. Rapp, 1997, p.82). Accordingly, it deals with the analysis of the behavior of market players and examines how information is received, selected and processed and how people act economically. In contrast to the capital market theory, which assumes that the actors in the financial markets maximize benefits or make a profit as the sole motive for action, behavioral finance assumes that the market participants also have other motives, such as fear, greed, euphoria, envy or altruism and fairness , can have. It also explains that there may be deviations from the fair market value on the market. These deviations can arise from market players who do not behave completely rationally (cf. Goldberg, von Nitzsch, 2004, p.25; Quitzau, 2004, p.3).

The aim of behavioral finance is to explain what happens on the financial markets with the help of human behavioral patterns. The behavior of the actors in the financial markets should be reproduced realistically. Psychological influencing factors should also be used to turn away from the ideal of a completely rational investor. For this it is necessary to identify systematic influencing factors on human decision-making behavior and to integrate them into financial theory models in order to be able to contribute to a solution of the various capital market anomalies (cf. Stanzel, 2007, p.101).

3.2 Behavioral Anomalies

Psychological research has shown that human behavior often deviates from the assumptions of capital market theory (see Rapp, 1997, p.83). (Behavioral) anomalies are understood as a systematic deviation of an individual from rational behavior. Accordingly, they are in contradiction to the economic image of man (cf. Frey, 1994, p.114). It is crucial that these behavioral anomalies do not occur randomly and independently of one another, but instead are systematically related to one another.

Behavioral anomalies are caused by so-called heuristics. "Heuristics are rules or strategies of information processing that achieve a quick, but not guaranteed optimal result with little effort, in short: rules of thumb" (Goldberg, von Nitzsch, 2004, p.49). Such heuristics are used consciously or unconsciously by individuals. This happens in particular if they are overwhelmed by the mass of information available to them or if they lack the necessary time to process it in detail (cf. Goldberg, von Nitzsch, 2004, p.49f).

Behavioral anomalies exist both in information perception and in information processing and decision-making, so that they can be divided into three categories within the framework of behavioral finance theory - anomalies of information perception, anomalies of information processing and anomalies of decision. Figure 2 shows that herd behavior can be classified under the category of decision anomalies.[8]

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Figure 2: Anomalies of human behavior (own illustration based on: Heidorn, Siragusano, 2004, p.4ff; Kowalewski, 2008, p.97ff; Roßbach, 2001, p.13f; Heun, 2007, p.133).


"Everybody doing what everyone else is doing, even when their private information suggests doing something quite different." (Banerjee, 1992, p.798)

4.1 Definition and characteristics of herd behavior

In nature one can often observe how animals instinctively come together to form a herd, for example to protect themselves from enemies or to go looking for food together. This aligned behavior can increase the individual's chances of survival (cf. Brudermann, 2010, p.54). Herd behavior can occur not only in the animal world, but also in human nature, in the fashion industry or in financial markets. People tend to be guided not only by their own experiences and instincts, but also by the behavior of others. They look for role models and research to what extent the behavior of these models has led to the goal and then imitate their actions (see Weber, 2007, p.100). Apart from that, many people find it difficult to move against the crowd. In particular, decision-making situations that are mainly characterized by uncertainty, disorientation or ignorance and in which one cannot fall back on their own experiences lead to people orienting themselves towards the behavior of others. But exuberant feelings such as fear or euphoria can also trigger such imitative behavior (see Fenzl, 2009, p.30). As early as 1895, Gustave Le Bon recognized that in a herd, emotions take precedence over the mind: "Your actions are much more often under the influence of the spinal cord than under that of the brain" (Le Bon, 1951, p.21). According to Shiller, emotional factors are even among the most important determinants of market exaggerations: "The emotional state of investors when they decide on their investments is no doubt one of the most important factors behind the bull market" (Shiller, 2005, p.65). There are innumerable decisions in everyday life in which people, without giving any thought to themselves, blindly orient themselves to the decisions of others or rely on their judgment. They imitate the actions of those who supposedly have a better level of knowledge and try to acquire better information in this way (cf. Bikhchandani et al., 1998, p.159). Consequently, herd behavior lies[9] before, when individuals orient themselves independently of their own opinion, on the decision-making behavior of others and therefore act in the same way as the masses, since they are of the opinion that the masses have better information than they do (cf. Bikhchandani, Sharma, 2001, P.280; Banerjee, 1992, p.798). In short, this financial market phenomenon describes the change in the behavior, expectation or opinion of a decision maker as a result of real or illusory (social) pressure. This pressure can on the one hand through mental processes, for example through a match in the perception and interpretation of information, and on the other hand through incentives or obligations are caused (see Oehler, Wendt, no year, p.13). The presence of incompletely informed actors and the influence of individual decisions by the decisions of others is therefore a prerequisite for the development of herd behavior (cf. Hott, 2004a; p.155; Zhu, 2009, p.13). In the market, this manifests itself in such a way that the behavior in the same direction leads to strong price or price fluctuations, as the market participants all invest in an investment opportunity or sell it again. The majority of investors have little in-depth knowledge and also do not have the time to make both sensible and sensible, as well as successful, investment decisions. Because of this, they do not make rational decisions under mass psychological framework conditions, i.e. based on fundamental data and rational-cognitive considerations, but react to the environment of the financial markets and try to imitate the prevailing market behavior (see Fenzl, 2009, p. 31; Rapp, 1997, p. 88). For example, if many investors buy the same shares because they follow the crowd, this leads to a price increase and vice versa (cf. Elger, Schwarz, 2009, p.148). One example is the share of the Austrian company BWIN, which was traded on the Vienna Stock Exchange in 2005 for well under 20 euros each. In mid-2006, the price of the share rose to over 100 euros as it was gradually bought by many market players for no apparent reason. After the euphoria subsided and panic spread due to the uncertainty about the further course of the share price, the market players began to sell their shares. Within a very short time, the share price fell back to below 20 euros. This behavior cannot be traced back to the fundamental data, as these have not changed in the short term to justify such drastic price fluctuations in such a short period of time (cf. Brudermann, 2010, p.17f). Such behavior of the market participants cannot be explained by the classical capital market theory, because in contrast to the theory of the rationally acting individual and the efficient markets, this mass psychological phenomenon testifies to the irrational behavior of the market participants. Thus, the occurrence of herd behavior justifies a lack of efficiency in the markets (see Hott, 2004a, p.49). This irrational behavior in the masses has an undesirable and negative effect on the general public, not only on the financial markets, but also in the real economy. Although the behavior in the same direction in the group as a whole can be described as irrational, as not all available information is included in the decision, this does not equally mean that the individuals behave individually irrationally. On the contrary - this irrational behavior in the crowd appears completely rational for the individual[10] (see Lähn, 2004, p.25). Basically, a distinction can be made between rational and irrational herd behavior.


[1] More details on the efficiency market hypothesis follow in Chapter 2.3.

[2] Arbitrage is usually understood to mean the risk-free exploitation of mispricing by two compensating financial transactions. It is assumed that there are perfect substitutes in the market, which are seldom available in reality (Klug et al., 2009, p.29).

[3] The random walk hypothesis assumes that price movements follow a random path and are therefore not predictable (cf. Murphy, 2003, p.37).

[4] Like fundamental analysis, technical analysis is used to forecast stock prices. Both forms of analysis pursue the same primary goal, but approach it in different ways. The technical analysis focuses in particular on the price history of traded products and examines these for regularities, which it uses to forecast the prices. Technicians use historical data to get clues about the direction of future price developments. The price and turnover developments to be examined are shown in charts, which are the primary source of information for the analysts. Because of its fundamental importance, technical analysis is often referred to as chart analysis (cf. Steiner, Bruns, 2002, p.248). Its aim is to identify trend progressions and their reversal points from the charts at an early stage and to anticipate them by means of suitable buy and sell limits (cf. Frey, Stahlberg, 1990, p.134).

[5] The aim of fundamental analysis is to determine the “true value” of a share, which is independent of the market price. If the intrinsic value of a share is higher than the current market value, it should be bought. However, if the intrinsic value is below the current market value, it should be sold. Fundamental analysis examines economic relationships on the basis of business data such as balance sheets or annual financial statements as well as economic data from the environment of a company. The knowledge gained from this serves as a basis for the formation of assumptions about future market development (cf. Frey, Stahlberg, 1990, p.133).

[6] An asymmetrical distribution of information means that not all market players have the same information at their disposal.

[7] The milestone of behavioral finance was laid by the American psychologist Daniel Kahnemann, who was able to prove that actual human behavior deviates from the theoretical model assumption of utility maximization. In 2002 he was awarded the Nobel Prize in Economics for his work (cf. Bergold, Mayer, 2005, p.12 and p.210).

[8] A detailed explanation of the individual anomalies is dispensed with at this point.

[9] It should be noted that empirically, it is difficult to distinguish herd behavior from a common reaction of market players to changes in fundamentals. Suppose interest rates rise unexpectedly, causing many market players to sell their stocks. In this case, there is no herd behavior because the actors orientate themselves on the publicly available information (fundamental data) and do not orient their behavior on the observations of the other actors (cf. Bikhchandani, Shama, 2001, p.281).

[10] Robert J. Shiller writes the following in this context: “Even completely rational people can participate in herd behavior when they take into account the judgments of others, and even if they know that everyone else is behaving in a herd like manner. The behavior, although individually rational, produces group behavior irrational ” (Shiller, 2000, p.151). It should be noted, however, that the understanding of rationality in this context is not to be equated with that of the homo oeconomicus, since incomplete information is assumed in the case of herd behavior.

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