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The models of portfolio selection and asset price dynamics in this volume seek to explain the market dynamics of asset prices. Presenting a range of analytical, empirical, and numerical techniques as well as several different modeling approaches, the authors depict the state of debate on the market selection hypothesis. By explicitly assuming the heterogeneity of investors, they present models that are descriptive and normative as well, making the volume useful for both finance theorists and financial practitioners.
* Explains the market dynamics of asset prices, offering insights about asset management approaches
* Assumes a heterogeneity of investors that yields descriptive and normative models of portfolio selections and asset pricing dynamics
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HANDBOOK OF FINANCIAL MARKETSDynamics and Evolution
North-HollandCopyright © 2009 Elsevier Inc.
All right reserved.
Chapter OneThought and Behavior Contagion in Capital Markets
David Hirshleifer and Siew Hong Teoh Merage School of Business University of California–Irvine
1.1. Introduction 2
1.2. Sources of Behavioral Convergence 5
1.3. Rational Learning and Information Cascades: Basic Implications 7
1.4. What Is Communicated or Observed? 9 1.4.1. Observation of Past Actions Only 10 1.4.2. Observation of Consequences of Past Actions 15 1.4.3. Conversation, Media, and Advertising 16
1.5. Psychological Bias 17
1.6. Reputation, Contracts, and Herding 18
1.7. Security Analysis 20 1.7.1. Investigative Herding 20 1.7.2. Herd Behavior by Stock Analysts and Other Forecasters 21
1.8. Herd Behavior and Cascades in Security Trading 24 1.8.1. Evidence on Herding in Securities Trades 24 1.8.2. Financial Market Runs and Contagion 27 1.8.3. Exploiting Herding and Cascades 28
1.9. Markets, Equilibrium Prices, and Bubbles 29
1.10. Cascades and Herding in Firm Behavior 36 1.10.1. Investment and Financing Decisions 36 1.10.2. Disclosure and Reporting Decisions 38
1.11. Contagion of Financial Memes 39
1.12. Conclusion 44 References 46
Prevailing models of capital markets capture a limited form of social influence and information transmission, in which the beliefs and behavior of an investor affect others only through market price, information transmission and processing is simple (without thoughts and feelings), and there is no localization in the influence of an investor on others. In reality, individuals often process verbal arguments obtained in conversation or from media presentations and observe the behavior of others. We review here evidence about how these activities cause beliefs and behaviors to spread and affect financial decisions and market prices; we also review theoretical models of social influence and its effects on capital markets. To reflect how information and investor sentiment are transmitted, thought and behavior contagion should be incorporated into the theory of capital markets.
Keywords: capital markets, thought contagion, behavioral contagion, herd behavior, information cascades, social learning, investor psychology, accounting regulation, disclosure policy, behavioral finance, market efficiency, popular models, memes
The theory of capital market trading and pricing generally incorporates only a limited form of social interaction and information transmission, wherein the beliefs and behavior of an investor affect other investors only through market price. Furthermore, in standard capital market models, there is no localized contagion in beliefs and trading. Trading behaviors do not move from one investor to other investors who are proximate (geographically, socially, professionally, or attentionally through connectivity in the news media). Even most recent models of herding and information cascades in securities markets involve contagion mediated by market price so that there are no networks of social interaction. Furthermore, existing behavioral models of capital market equilibrium do not examine how investors form naïve popular ideas about how capital markets work and what investors should do, and how such popular viewpoints spread.
The theory of investment has incorporated social interactions somewhat more extensively, both in the analysis of increasing returns and path dependence (see Arthur, 1989) and in models of social learning about the quality of investment projects (discussed in Section 1.10.1). However, traditional models of corporate investment decisions do not examine the process of contagion among managers of ideas about investment, financing, disclosure, and corporate strategy.
In reality, individuals often observe others' behavior and obtain information and ideas through conversation and through print and electronic media. Individuals process this information through both reasoning and emotional reactions rather than performing the simple Bayesian or quasi-Bayesian updating of standard rational or behavioral models. Popular opinions about investment strategies and corporate policies evolve over time, partly in response to improvements in scientific understanding and partly as a result of psychological biases and other social processes. We are influenced by others in almost every activity, and price is just one channel of influence. Such influence can occur through rational learning (see, e.g., Banerjee, 1992; Bikhchandani, Hirshleifer, and Welch, 1992) or through through irrational mechanisms (see Section 1.5), the latter including the urge to conform (or deviate) and contagious emotional responses to stressful events.
This essay reviews theory and evidence about the ways beliefs about and behaviors in capital markets spread. We consider here decisions by investors about whether to participate in the stock market and what stocks to buy; decisions by managers about investment, financing, reporting, and disclosure; and decisions by analysts and media commentators about what stocks to follow, what stocks to recommend, and what forecasts to make. We also consider the effects of contagion on market prices, regulation, and welfare as well as policy implications.
We argue that in actual capital markets, in addition to learning from price, a more personal form of learning is also important: from quantities (individual actions), from performance outcomes, and from conversation—which conveys private information, ideas about specific assets, and ideas about how capital markets work. Furthermore, we argue that learning is often local: People learn more from others who are proximate, either geographically or through professional or other social networks. We therefore argue that social influence is central to economics and finance and that contagion should be incorporated into the theory of capital markets.
Several phenomena are often adduced as evidence of irrational conformism in capital markets, such as anecdotes of market price movements without obvious justifying news; valuations which, with the benefit of hindsight, seem like mistakes (such as the valuations of U.S. Internet stocks in the late 1990s or of mortgage-backed securities in recent years); the fact that financial activity such as new issues, IPOs, venture capital financing, and takeovers move in general or sector-specific waves (see, e.g., Ritter and Welch, 2002; Rau and Stouraitis, 2008). Observers are often very quick to denounce alleged market blunders and conclude that investors or managers have succumbed to contagious folly.
There are two problems with such casual interpretations. First, sudden shifts do not prove that there was a blunder. Large price or quantity movements may be responses to news about important market forces. Second, even rational social processes can lead to dysfunctional social outcomes.
With respect to the first point, market efficiency is entirely compatible with massive ex post errors in analyst forecasts and market prices and with waves in corporate transaction actions in response to common shifts in fundamental conditions.
With respect to the second point, the theory of information cascades (defined in Section 1.2) and rational observational learning shows that some phenomena that seem irrational can actually arise naturally in fully rational settings. Such phenomena include (1) frequent convergence by individuals or firms on mistaken actions based on little investigation and little justifying information; (2) fragility of social outcomes with respect to seemingly small shocks; and (3) the tendency for individuals or firms to delay decision for extended periods of time and then, without substantial external trigger, suddenly to act simultaneously. Furthermore, theoretical work has shown that reputation-building incentives on the part of managers can cause convergent behavior (Item 1) and has also offered explanations for why some managers may deviate from the herd as well. So care is needed in attributing either corporate event clustering or large asset price fluctuations to contagion of irrational errors.
In addition to addressing these issues, we consider a shift in analytical point of view from the individual to the financial idea or meme. A meme, first defined by Dawkins (1976), is a mental representation (such as an idea, proposition, or catchphrase) that can be passed from person to person. Memes are therefore units of cultural replication, analogous to the gene as a unit of biological heredity. The field of memetics views cultural units as replicators, which are selected upon and change in frequency within the population. Just as changes in gene frequency imply evolution within biologically reproducing populations, changes in meme frequency imply cultural evolution. We argue that certain investment theories have properties that make them better at replicating (more contagious or more persistent), leading to their spread and survival.
Furthermore, we argue that through cumulative evolution, financial memes combine into coadapted assemblies that are more effective at replicating their constituent memes than when the components operate separately. We call these assemblies financial ideologies. Memetics offers an intriguing analytical approach to understanding the evolution of capital market (and other) popular beliefs and ideologies.
Only a few finance scholars have emphasized the importance of popular ideas about markets (especially Robert Shiller, as mentioned in Footnote 1), and there has been very little formal analysis of the effects and spread of popular financial ideas. We argue here that the analysis of thought contagion and the evolution of financial ideologies, as well as their effects on markets, constitute a missing chapter in modern finance, including behavioral finance.
Our focus is on contagion of beliefs or behavior rather than defining contagion as occurring whenever one party's payoff outcomes affect another's. Therefore we do not review systematically the literature on contagion in bankruptcies or international crises in which fundamental shocks and financial constraints cause news about one firm or region to affect the payoffs of another.
Section 1.2 discusses learning and the general sources of behavioral convergence. Section 1.3 discusses basic implications of rational learning and information cascades. Section 1.4 discusses basic principles of rational learning models and alternative scenarios of information transfer by communication or observation. Section 1.5 examines psychological bias and herding. Section 1.6 describes agency and reputation-based herding models. Section 1.7 describes theory and evidence on herding and cascades in security analysis. Section 1.8 describes herd behavior and cascades in security trading. Section 1.9 describes the price implications of herding and cascading. Section 1.10 discusses herd behavior and cascading in firms' investment, financing, and disclosure decisions. Section 1.11 examines the popular models or memes about financial markets. Section 1.12 concludes.
Excerpted from HANDBOOK OF FINANCIAL MARKETS Copyright © 2009 by Elsevier Inc.. Excerpted by permission of North-Holland. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents"Introduction"--Thorsten Hens and Klaus Reiner Schenk-Hoppé
1. "Thought and Behavioral Contagion in Capital Markets"--David Hirshleifer and Siew Hong Teoh
2. "How markets digest supply and demand and slowly incorporate information into prices"--Jean-Philippe Bouchaud, J. Doyne Farmer, and Fabrizio Lillo
3. "Stochastic Behavioral Asset Pricing Models and the Stylized Facts"--Thomas Lux
4. "Complex Evolutionary Systems in Behavioral Finance"--Cars Hommes and Florian Wagener
5. "Heterogeneity, Market Mechanisms, and Asset Price Dynamics"--Carl Chiarella, Xue-Zhong He and Roberto Dieci
6. "Perfect Forecasting and Behavioral Heterogeneities"--Jan Wenzelburger
7. "Market Selection and Asset Pricing"--Lawrence Blume and David Easley
8. "Rational Diverse Beliefs and Market Volatility"--Mordecai Kurz
9. "Evolutionary Finance"--Igor V. Evstigneev, Thorsten Hens, Klaus Reiner Schenk-Hoppé