Economics

Industry Herding And The Momentum Effect

Industry Herding And Momentum via SSRN

Yan Zhao

City College – City University of New York

Zhipeng Yan

New Jersey Institute of Technology

Libo Sun

California State Polytechnic University, Pomona – Finance, Real Estate and Law Department

March 19, 2012

Journal of Investing, Vol. 21, 2012

Abstract:

Theoretical models on herd behavior predict that under different assumptions, herding can bring prices away (or towards) fundamentals and reduce (or enhance) market efficiency. In this article, we study the joint effect of herding and momentum at the industry level. We find that the momentum effect is magnified when there is a low level of investor herding. Herd behavior in investors helps move asset prices towards fundamentals, enhance market efficiency and reduce the momentum effect. A trading strategy taking a long position in winner industries and a short position in loser industries when the herding level is low can generate significant returns.

Industry Herding And The Momentum Effect – Introduction

Herd behavior, or the tendency of individuals in a group to “follow the trend,” has frequently been observed in equity markets. Herd behavior in investors leads to a convergence of action (Hirshleifer and Teoh [2003]).

There are at least two important strands of literature on herd behavior. The first is that mutual imitation among investors may temporarily drive asset prices away from fundamental values, and move the market toward inefficiency in an information cascade (Banerjee [1992]; Bikhchandani et al. [1992]; Bikhchandani and Sharma [2001]). The second strand shows that uninformed traders can become informed by imitating the observed movement in the market. In that way, herd behavior in investors may help impound information about fundamentals into asset prices and enhance market efficiency (Froot et al. [1992]; Hirshleifer et al. [1994]; Hey and Morone [2004]).

This article aims to address the question of whether or not herd behavior enhances market efficiency at the industry level. To answer this question, we study the joint effect of herd behavior and the momentum effect on industry average prices over the period of 1980 to 2008. We find that the momentum effect is magnified when there is a low level of investor herding. Herd behavior in investors helps move asset prices toward fundamentals, enhances market efficiency, and reduces the momentum effect. A trading strategy taking a long position in winner industries and a short position in loser industries when the herding level is low can generate significant returns.

Herding and the momentum effect are closely related to each other. Jegadeesh and Titman [1993, 2001] first documented stock price momentum. Stocks that have previously exhibited positive returns (winners) continue to outperform stocks that have previously exhibited negative returns (losers). One possible explanation for the momentum effect is that if herding can help impound fundamental news into asset prices and enhance market efficiency, then investor herding will accelerate the rate of movement to efficiency, so stocks with a low level of herding will exhibit the momentum effect more than stocks with a high level of herding.

The existing theories of herding make no definite a priori predictions about the impact of investor herding activity on the momentum effect at the industry level, thus our approach is strictly empirical. We find that a low level of herding significantly enhances stock price momentum. Winner industries with a low level of herding generate higher subsequent returns than those with a high level of herding. Loser industries with a low level of herding generate lower subsequent returns than those with a high level of herding. We conclude that the herd effect plays an important role in the momentum effect and has predictive power in future price movement. We show that acting in a herd, investors help move asset prices toward fundamentals, enhance market efficiency, and reduce the momentum effect.

Herding

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