A market behavior known as herding is not as important a trend as economists previously assumed, according to a recent paper by SFI Professors Doyne Farmer and Fabrizio Lillo and their colleagues.
The agent-based models the researchers are developing can give economists another tool to explore policy scenarios and avoid a repeat of the financial crisis that began in 2008, which traditional economic models failed to predict. Those traditional models consider herding a dominant behavior of investors. Data the researchers analyzed from the London Stock Exchange, however, did not shore up an assumption that herding plays a major role.
“There is some herding, especially for very short time lengths,” says Lillo in describing the intraday persistence of order flow, a trend in which buy orders follow buy orders or sell orders follow sell orders. “But the dominant component is order splitting,” he concludes, “at least at the broker level.”
Herding occurs when investors imitate others or act together in response to a signal such as a press release or price change. Order splitting by brokers minimizes the impact of big orders on price by splitting the orders into pieces and gradually executing them.
The researchers new technique for distinguishing between the behaviors and identifying which is dominant in market trends could be important for examining other data sets as well, and in developing more accurate agent-based models of the economy, Lillo says.
Read the paper on arXiv
Read the article in the SFI Update (March-April 2012)
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