Herd Behavior in a Laboratory Financial Market

Abstract

We study herd behavior in a laboratory financial market. Subjects receive private information on the fundamental value of an asset and trade it in sequence with a market maker. The market maker updates the asset price according to the history of trades. Theory predicts that agents should never herd. Our experimental results are in line with this prediction. Nevertheless, we observe a phenomenon not accounted for by the theory. In some cases, subjects decide not to use their private information and choose not to trade. In other cases, they ignore their private information to trade against the market (contrarian behavior).

Do We Follow Others When We Should? A Simple Test of Rational Expectations

“…E.g. if the participant 1 2 But with the quali…er about Cipriani and Guarino (2005) -see the previous footnote. 1 3 Information on !i is available for each decision -which is crucial for estimating the empirical value of each action -thanks to the "no-lying-to-subjects" policy in experimental economics: all urn and signal draws in the experiments were actually made according the described process, and not made up by the experimenters.…”

Reputational Herding in Financial Markets: A Laboratory Experiment

“…However, sufficiently long trends might not emerge. While the settings are slightly different, experiments on social learning in financial markets (see, e.g., Cipriani and Guarino [2005], Drehmann, Oechssler and Roider [2005]) have documented a strong tendency of investors to engage in "contrarian behavior" (i.e., the higher the market price of an asset, the less likely are investors to buy this asset). As a consequence, even with a longer sequence of investors, asset prices might fail to become sufficiently extreme for reputational concerns to outweigh profits from trading according to one's own information.…”

“…and the price of Asset B is equal to p t B D 10 ¢ Prob(BjH t , buy B), where H t denotes the history of observable decisions of all earlier investors up to time t. Other experiments (such as Drehmann, Oechssler and Roider [2005], Cipriani and Guarino [2005]) have assumed that the market maker does not condition the prices p t A and p t B on the kind of order he or she receives at time t (and, hence, is not fully profit-maximizing). We deviate from this and assume the price-setting rule (1) because it facilitates more "extreme" prices earlier on in a given sequence of investors.…”

“…However, for the case of Investor 3, the market maker will suspect herd behavior if H 3 2 {AA,BB}, and, in this case, a profit-maximizing market maker would confront Investor 3 with market prices that deviate from Table 1. In the experiment, market prices that differ across treatments would, however, be problematic as earlier studies have shown that price levels per se influence subjects' inclination to follow their own signal (see, e.g., Cipriani and Guarino [2005], Drehmann, Oechssler and Roider [2005]). In particular, there is evidence for contrarian behavior, where subjects are more likely to act against their signal, if prices are higher.…”

“…This finding is interesting in the light of the earlier experimental literature on herding in financial markets. For example, various experiments studying informational cascades in markets with flexible prices find that imitation seems to occur only rarely (see, e.g., Cipriani and Guarino [2005], Drehmann, Oechssler and Roider [2005] Two benchmarks: equilibrium wages and behavioral wages. To evaluate the actual wage setting by principals in the experiment, we calculate two benchmark wages.…”