India Economy

Herd behaviour

D. MURALI | Updated on May 26, 2012


“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” With this quote of Charles Mackay (1841) opens Herd Behaviour in Financial Markets by Sushil Bikhchandani and Sunil Sharma (IMF, 2001).

The authors note that in emerging markets, one is likely to find a greater tendency to herd. They reason that, in these markets, where the environment is relatively opaque because of weak reporting requirements, lower accounting standards, lax enforcement of regulations, and costly information acquisition, information cascades and reputational herding are more likely to arise. “Also, because information is likely to be revealed and absorbed more slowly, momentum investment strategies could be potentially more profitable.”

The authors refer to Avery and Zemsky (1998) for the view that the availability of derivatives may make herding and price bubbles less pronounced, since multidimensional stock prices are better equipped to reveal multidimensional uncertainty. For those following the ‘herd,' another paper to read is that of Paresh Kumar Narayan and Xinwei Zheng, titled Fresh Evidence on herding Behaviour from the Chinese Stock Market ( www.ssrn.com).

Earnings guidance

If one were to say that more transparent financial reporting of earnings is related to lower stock price crash risk, you may quite likely nod in agreement. But Management Earnings Guidance and Stock Price Crash Risk by Sophia J. W. Hamm, Edward X. Li, and Jeffrey Ng ( www.ssrn.com) differs from this view of Hutton, Marcus, and Tehranian (JFE, 2009).

Hutton et al. had said that opaque earnings are associated with higher stock price crash risk and that transparent financial reporting is important for stability in capital markets. An important assumption underlying this typical view is that managers truthfully reveal private information through guidance, write Hamm et al.

They cite McKinsey (2006) for the finding that the practice of guidance has become “misguided” as there is an excessive focus on short-term “number games” rather than long-term firm health and future business conditions. “This myopic focus and managerial incentives could induce managers to sugar-coat poor business conditions with misleading guidance, which leads to further opportunistic behaviours, such as earnings management, to meet or beat the earlier guidance.”

A disturbing conclusion of the paper is that more earnings guidance is associated with a higher likelihood of a future stock price crash. “We also find that the perverse effect of guidance in increasing the crash risk is more pronounced when firms have higher executive stock ownership, but that it is attenuated when there are higher dedicated institutional holdings or higher litigation risk.”

The paper, therefore, urges one to recognise the agency problems in corporate disclosure, especially if the disclosures are voluntary and/or non-audited. In particular, as the authors underline, “managers have incentives to distort the disclosures as long as recipients are unable to completely unravel the distortions and when the managers are compensated by the disclosure's outcome.”

Cautionary study.

Published on May 12, 2012

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor