Investors' Herd Behavior: Rational or Irrational?

• Author: Shih‐Chuan Tsai,William T. Lin,Pei‐Yau Lung
• DOI: http://doi.org/10.1111/ajfs.12030
• Published date: 01 October 2013
• Date: 01 October 2013

Investors’ Herd Behavior: Rational or

Irrational?*

William T. Lin

Department of Banking and Finance, Tamkang University

The Center for Research of Private Economy, Zhejiang University

Shih-Chuan Tsai**

College of Management, National Taiwan Normal University

Pei-Yau Lung

Department of Banking and Finance, Tamkang University

Received 30 October 2011; Accepted 12 June 2013

Abstract

This study examines the relationships between the herding of various investor groups and

trading noise in the Taiwan stock market to determine whether any of the investor groups

tend to herd rationally. The study uses a unique and comprehensive data set on intraday

transactions and limit order books of the Taiwan Stock Exchange (TWSE). We calculate the

high-frequency herding measures and trading noise in a call auction market. We find that

institutional investors are likely to be informed traders and herd rationally based on superior

information. Institutional investors’ herding has a negative impact on trading noise. Their

buy (sell) herding predicts positive (negative) future market returns. By contrast, the herding

of individual investors tends to contain limited information, as it increases trading noise; the

buy (sell) herding of individuals is negatively correlated with future market returns. These

findings are more significant for stocks with higher turnover.

Keywords Trading noise; Herding; Institutional investors; Individual investors; Intraday

transactions.

JEL Classification: G1,G12,G14,G15,L11

*Acknowledgements: The authors thank the editors and the two anonymous referees for their

constructive comments. The authors also acknowledge the financial support from National

Science Council of Taiwan (Grant no. NSC 99-2410-H-032-030-), as well as the Taiwan Stock

Exchange for data support.

**Corresponding author: Shih-Chuan Tsai, 11F-2, No.18, Jin-Shan South Road, Section 2,

Taipei, Taiwan. Tel: +886-277343299, Fax: +886-2-23222668. email: chuant@ntnu.edu.tw.

Asia-Pacific Journal of Financial Studies (2013) 42, 755–776 doi:10.1111/ajfs.12030

©2013 Korean Securities Association 755

1. Introduction

Herding is a common phenomenon in behavioral finance. Nofsinger and Sias

(1999) define herding as a group of investors trading in the same direction over a

period of time. Recently, investor herd behavior has attracted increasingly more

attention, both within and outside of academia.

1

Previous empirical work has mainly focused on apparent herding or its impact.

However, it might be equally important to focus on the causes driving investors to

cluster their trades, because diverse causes of herding may result in distinct effects on

financial markets. This paper examines whether investor herd behavior is rational or

irrational, and distinguishes information-based from non-information-based herding.

Welch (1996) reports that proponents of the view that herd behavior is irratio-

nal believe that investors follow one another blindly and forgo rational analysis.

Devenow and Welch (1996) classify herding into rational herding and irrational

herding. Rational herding is information-based; rational investors with similar stock

preferences adopt the same response to similar information about company charac-

teristics and fundamentals. When the herding of investors is rational in response to

new information, herding moves prices toward the fundamental value of assets;

price movement is not likely to reverse. By contrast, irrational herding occurs when

investors with insufficient information and inadequate risk evaluation disregard

their prior beliefs and blindly follow other investors’ actions. Non-information-

based herding might lead to market inefficiencies, drive asset prices away from fun-

damental values, and cause asset mispricing (Froot et al., 1992; Hirshleifer et al.,

1994; Hwang and Salmon, 2004; Hung et al., 2010).

It is not easy to precisely distinguish rational herding from irrational herding.

Prior research suggests that trading noise in financial markets mainly stems from

investor irrationality and information asymmetries (DeLong et al., 1990; Admati,

1991). Stoll (2000) suggests that trading noise is friction that accompanies investor

trading. Friction can be higher among investors who are not equipped with sufficient

information. Hu (2006) extends the notion of friction to propose a valid measure of

trading noise in a call auction market. The current paper argues that trading noise

in the market increases if many investors trade without information, in the case of

herding caused by many uninformed investors blindly following one another. This

paper adopts the measure of trading noise used in Hu (2006) to examine the rela-

tionship between herding and trading noise on the Taiwan Stock Exchange (TWSE).

We determine the rationality of herding in a particular investor group by assessing

the level of trading noise in the market after herding by the investor group.

There is growing concern in the literature about the herding behavior in emerg-

ing stock markets, especially the Taiwan stock market, which is a market dominated

1

See related research, including Bikhchandani et al. (1992), Choe et al. (1998), Jones et al.

(1999), Wermers (1999), Bowe and Domuta (2004), Chen and Hong (2006), Uchida and

Nakagawa (2007), Lin et al. (2007), and Demirer et al. (2010).

W. T. Lin et al.

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