Co-authored by Asif Khan, CFA and Sajib Hossain, Lecturer of finance at Dhaka University. Original article appeared at Dhaka Tribune Website.
They are also expected to be independent of market noise and bias. Now, if such investors were really rational, they would get analytical information in advance, and use that while investing. Other participants would then follow the informed investors, resulting in efficient pricing of market instruments.However, reality reflects something different. Perhaps, rational investor behavior is ignored by other participants, resulting in irrational behavior in the overall market. Or perhaps, the size and participation of rational investors is not large enough to have an effect on irrational investors.Investment sophistication and financial skill and knowledge among market participants are rapidly growing in our market. However, free flow of information, more research based periodic reviews and quality corporate disclosures are not increasing at the same pace.Herding in emerging markets, like Bangladesh, may also be attributed to incomplete regulatory frameworks, especially in the area of market transparency. Insider traders have been consistently taking undue advantage, and are able to persuade the crowd to follow them, ignoring fundamental information. The Bangladesh Securities and Exchange Commission either fails to detect and prevent such insider trading, or the market regulator fails to take punitive action because of undue influence or lack of sufficient means. Moreover, deficiencies in corporate disclosures and information quality create uncertainty in the market, throw doubt on the reliability of public information and impede fundamental analysis. A recent study (unpublished) by Accounting for the Capital Market Development, a research project sponsored by WB and UGC, found that audited financial statements of a good number of listed companies contained unqualified audit opinion by reputed firms and were not prepared according to international standards.
So, it is reasonable to assume that investors will lose belief in analysis-driven investment strategy, and thus, prefer to base trading on their peers’ actions. Alongside intentional herding, unintentional herding also occurs in the market here due to simultaneous reaction to a common signal.
However, herding does not always result in an inefficient outcome that impedes proper functioning of the market. Herding can have an efficient outcome, provided it comes from the simultaneous reaction on fundamental values. In this case, it speeds up price adjustments, making the market more efficient.
But herding not based on fundamental values may drive prices away from the latter, which can result in subsequent return reversals. In this case, asset prices will fail to reflect fundamental information.
Herding behaviour, especially of retail investors who are dominant in daily trading, can destabilize markets, with the potential to create, or at least contribute to, bubbles and crashes in the capital market.
Therefore, properly scrutinizing and assessing the types, causes and extent of herding and ensuring that such behavior is driven by fundamentals are essential for efficient functioning of the capital market in Bangladesh.