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How herding behaviour deters capital market price efficiency in Bangladesh

  • Published at 04:43 am May 20th, 2013
How herding behaviour deters capital market price efficiency in Bangladesh

Identical investments in the Bangladesh capital market, without any significant shifts in economic fundamentals, can be explained partially by the herding behaviour of investors. This is where investors discard their fundamental analysis of stocks and follow the crowd.

A high level of herding may be evident from the fact that when the stock market falls, all participants go down the same path.

Similarly, when the index experiences some upward trend, market participants follow.

Surely, such herding behaviour can also be attributed to a poorly regulated environment, lack of quality and timely disclosures, and the type and sophistication of both retail and institutional investors.

Many investors, believing some particular stocks to be very risky or overvalued, or vice versa, still buy or sell the same stocks discarding their personal opinions, which is a market phenomenon here.

Sometimes such behaviour turns into a pattern that deters market efficiency. Investors do not seem to have taken any lesson from the recent bubble and burst in the market, as they keep on repeating the same behaviour.

Rational investors, especially institutional ones, are expected to make an investment decision taking into account full financial and operation aspects, and the growth prospects of stocks being considered.

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 behaviour is ignored by other participants, resulting in irrational behaviour 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 destabilise markets, with the potential to create, or at least contribute to, bubbles and crashes in the capital market.

Therefore, proper scrutinising and assessing the types, causes and extent of herding _ and ensuring that such behaviour is driven by fundamentals _ are essential for efficient functioning of the capital market in Bangladesh. 

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