Herding and overreaction: a threat to financial stability in developed and emerging markets
image: Illustrates the sharp drop in the S&P500 from 3203 to 2571, while the VIX spiked to 53.5, highlighting the market volatility and investor fear during the pandemic.
Credit: Ooi Kok Loang (Universiti Malaya, Malaysia).
Background and Motivation
Financial markets are essential to global economic activity, yet they are often disrupted by behavioural biases such as herding and overreaction, which can amplify volatility and systemic risk. While these phenomena have been studied in isolation, their combined impact on financial stability—especially across different types of markets—remains underexplored. China Finance Review International (CFRI) brings you an article titled “Financial stability at risk: evidence from market overreaction and herding behaviour in developed and emerging markets”, which examines how these behaviours interact and affect financial stability in both developed and BRICS markets.
Methodology and Scope
The study uses a comprehensive dataset from 2017 to 2023, covering major stock indices in the U.S., Japan, the U.K., France, and the BRICS nations. It applies advanced econometric techniques, including panel data regression, quantile regression, Granger causality tests, and the Baron and Kenny mediation model. Key metrics include the Cross-Sectional Absolute Deviation (CSAD) for herding behaviour, the Abnormal Excess Cumulative Return (AECR) for market overreaction, and the Garman-Klass volatility estimator for financial stability.
Key Findings and Contributions
- Herding behaviour is present in both developed and BRICS markets, but it is more pronounced in BRICS countries, especially during market downturns.
- Herding significantly exacerbates short-term market overreaction, which in turn increases financial instability.
- Market overreaction fully mediates the relationship between herding and financial stability, particularly in BRICS markets.
- Developed markets show greater resilience due to stronger regulatory frameworks and investor sophistication.
Why It Matters
These findings challenge the Efficient Market Hypothesis and underscore the importance of behavioural finance in understanding real-world market dynamics. The study highlights how psychological factors and collective investor behaviour can lead to significant deviations from fundamental values, increasing systemic risk—especially in less mature markets.
Practical Applications
- For Regulators: Implement differentiated market interventions, enhancing real-time monitoring and circuit breakers in emerging markets like BRICS, while optimising trading mechanisms and information disclosure in developed markets.
- For Investors: Maintain awareness of behavioural biases and exercise independent judgment during extreme market volatility, utilising quantitative indicators to identify potential reversal opportunities.
- For Financial Institutions: Integrate behavioural metrics into risk management frameworks and develop investor education programs to help clients mitigate herd mentality.
- For Academia: Further investigate cross-market behavioural contagion mechanisms and develop methodologies to better distinguish between rational co-movement and irrational herding.
Discover high-quality academic insights in finance from this article published in China Finance Review International. Click the DOI below to read the full-text original! Open access for a limited time!