NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Herd Mentality Takes over in Market Crisis



"Herd behavior among all institutional investors increased significantly during the Korean economic crisis. "

In Foreign Portfolio Investors Before and During a Crisis (NBER Working Paper No. 6968) , Woochan Kim and Shang-Jin Wei analyze foreign investors' stock positions before and during the Korean economic crisis of 1997-8 and observe that in the midst of the turmoil, there was a convergence in behavior among all types of foreign investors -- institutional and individual, resident and non-resident -- that wasn't there before the trouble started. Kim and Wei note that when the crisis hit, almost all investors tended to sell stocks whose prices were plummeting and buy those whose prices were rising, a pattern known as "positive feedback trading."

The authors observe that before the crisis, foreign institutional traders who resided in Korea tended to sell their "recently best performing stocks and buy the recently worse performing stocks." But when faced with economic instability, they started doing the opposite: namely, what everybody else was doing. Meanwhile, the crisis re-enforced the tendency of non-resident institutional investors to "aggressively" sell recent losers.

Overall, Kim and Wei find that herd behavior among all institutional investors increased significantly during the Korean economic crisis. As for individual investors, the authors find that the herd instinct before the crisis hit was already stronger than among institutional investors -- this did not change that much when the economy soured. Also, when the authors compare residents to non-residents from both categories -- institutional and individual -- they find that the urge to herd was generally stronger among non-residents.

As Kim and Wei point out, studying the extent to which investors "mimic each other's behavior" instead of studying market fundamentals can shed light on how investor decisions can unnecessarily exacerbate an economic crisis. They also note that it can be relevant for the discussion on the desirability of capital controls.

Of course, herd behavior might not be such a bad thing if, in fact, it could be explained as all investors shrewdly utilizing useful information and pursuing the same winning strategy. But Kim and Wei find that the herd appears to have been running in the wrong direction. According to their evidence, investors would have made more money if they had bought stocks that had recently tanked and sold those that were on the up-tick. "The recent past losers outperform the recent winners, in a statistically significant and quantitatively large way, over one-month, two-month and so on, all the way to five month horizons," the authors state. "Again, a contrarian strategy (buying recent losers, selling recent winners) rather than a positive feedback one would have been more profitable."

One final note: Kim's and Wei's study also re-affirms the Wall Street Journal's extraordinary influence on the decisions of investors outside Korea. The authors report that non-resident institutional investors buying Korean stocks tend to focus their herding behavior on "19 stocks regularly reported in the Wall Street Journal" more than any other stocks, including those of the top five Korean conglomerates.

-- Matthew Davis


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