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When Herding and Contrarianism Foster Market Efficiency: A Financial Trading Experiment

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  • Andreas Park
  • Daniel Sgroi

Abstract

While herding has long been suspected to play a role in financial market booms and busts, theoretical analyses have struggled to identify conclusive causes for the effect. Recent theoretical work shows that informational herding is possible in a market with efficient asset prices if information is bi-polar, and contrarianism is possible with single-polar information. We present an experimental test for the validity of this theory, contrasting with all existing experiments where rational herding was theoretically impossible and subsequently not observed. Overall we observe that subjects generally behave according to theoretical predictions, yet the fit is lower for types who have the theoretical potential to herd. While herding is often not observed when predicted by theory, herding (sometimes irrational) does occur. Irrational contrarianism in particular leads observed prices to substantially differ from the efficient benchmark. Alternative models of behavior, such as risk aversion, loss aversion or error correction, either perform quite poorly or add little to our understanding.

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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-316.

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Length: 48 pages
Date of creation: 29 Apr 2008
Date of revision:
Handle: RePEc:tor:tecipa:tecipa-316

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Keywords: Herding; Informational Efficiency; Experiments.;

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  1. Chari, V. V. & Kehoe, Patrick J., 2004. "Financial crises as herds: overturning the critiques," Journal of Economic Theory, Elsevier, Elsevier, vol. 119(1), pages 128-150, November.
  2. Mathias Drehmann & Joerg Oechssler & Andreas Roider, 2002. "Herding and Contrarian Behavior in Financial Markets - An Internet Experiment," Finance, EconWPA 0210005, EconWPA.
  3. Smith, L. & Sorensen, P., 1996. "Pathological Outcomes of Observational Learning," Economics Papers 115, Economics Group, Nuffield College, University of Oxford.
  4. Cipriani Marco & Guarino Antonio, 2008. "Herd Behavior and Contagion in Financial Markets," The B.E. Journal of Theoretical Economics, De Gruyter, De Gruyter, vol. 8(1), pages 1-56, October.
  5. McKelvey Richard D. & Palfrey Thomas R., 1995. "Quantal Response Equilibria for Normal Form Games," Games and Economic Behavior, Elsevier, Elsevier, vol. 10(1), pages 6-38, July.
  6. Alevy, Jonathan E. & Haigh, Michael S. & List, John A., 2003. "Information Cascades: Evidence From A Field Experiment With Financial Market Professionals," Working Papers, University of Maryland, Department of Agricultural and Resource Economics 28608, University of Maryland, Department of Agricultural and Resource Economics.
  7. Marco Cipriani & Antonio Guarino, 2005. "Herd Behavior in a Laboratory Financial Market," American Economic Review, American Economic Association, American Economic Association, vol. 95(5), pages 1427-1443, December.
  8. Andreas Park & Hamid Sabourian, 2011. "Herding and Contrarian Behavior in Financial Markets," Econometrica, Econometric Society, Econometric Society, vol. 79(4), pages 973-1026, 07.
  9. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198296980, October.
  10. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, Springer, vol. 5(4), pages 297-323, October.
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Cited by:
  1. Asen Ivanov & Dan Levin & James Peck, 2008. "Hindsight, Foresight, and Insight: An Experimental Study of a Small-Market Investment Game with Common and Private Values," Working Papers, VCU School of Business, Department of Economics 0801, VCU School of Business, Department of Economics.
  2. Hirshleifer, David & Teoh, Siew Hong, 2008. "Thought and Behavior Contagion in Capital Markets," MPRA Paper 9164, University Library of Munich, Germany.
  3. Park, Andreas & Sgroi, Daniel, 2008. "Herding and Contrarianism in a Financial Trading Experiment with Endogenous Timing," The Warwick Economics Research Paper Series (TWERPS), University of Warwick, Department of Economics 868, University of Warwick, Department of Economics.

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