Herding and Contrarianism: A Matter of Preference?
Abstract: Herding and contrarian strategies in financial markets produce informational inefficiencies because investors ignore private information, instead following or bucking past trends. In a simple trading environment, I demonstrate theoretically that investors with prospect theory preferences ignore private information by following a strategy that looks like herding or contrarianism, but which is actually trend-independent. I confirm the theory's predictions in a laboratory experiment designed to rule out other sources of these behaviors, and find that approximately 70% of subjects exhibit herd-like behavior. Finally, I perform a calibration exercise using actual market data to demonstrate the applicability of the results to more general settings
Finance Seminars at Caltech are funded through the generous support of The Ronald and Maxine Linde Institute of Economic and Management Sciences (lindeinstitute.caltech.edu) and Stephen A. Ross.