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3% rules the market: herding behavior of a group of investors, asset market volatility, and return to the group in an agent-based model

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Abstract

This study presents an agent-based model of capital markets by adopting simple trading rules for bounded rational agents who maintain different expectations regarding a tipping point at which price starts to change its direction from rising (falling) to falling (rising). The effect of herding behavior on the volatility of stock market prices and the rate of return to the herding group are investigated by dividing agents into one or more groups. Herding behavior by a group of agents leads to high market volatility and high return for the agents in the group. Maximum rate of return is reached when the group size is approximately 3% of the total number of agents. This finding is consistent with the actual degree of herding behavior in markets found by empirical studies. However, the rates of return decrease when the group size exceeds 3%, and the premium of the herding group tends to disappear when the group size reaches a certain level (20%) compared with that of non-herding groups. Reducing the number of groups (or increasing the average size of the herding groups) leads to high price volatility.

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Notes

  1. Quarda et al. (2013) contended that a strong relationship exists between herding behavior, volatility, and trading volume. Krichene and El-Aroui (2018) defined herding behavior as an attitude of uninformed agents following many informed agents’ strategies. They mixed the models of existing ABMs with the social network model and suggested that high information asymmetry and herding behavior can be considered the main determinants of the microstructure of an immature stock market. Cont (2005) focused on the phenomenon of volatility clustering and discussed several ABMs that can generate such a clustering to explain their mechanisms.

  2. In the literature cited here, fundamentalists make trading decisions according to estimates of the fundamental value of an asset, whereas chartists use the previous price trends as basis for decisions. If an agent knows both types of information, namely the fundamental value of the asset and the history of price change rate, then assuming that both types of information are used is reasonable.

  3. This assumption is also made in Lee and Lee (2015).

  4. The underlying model in this paper is the same as the one in Lee and Lee (2015) where further details of the model can be found.

  5. By contrast, fundamental values are assumed to be constant in Chiarella and Iori (2002).

  6. Our trading rules do not assume any type of utility function.

  7. These values are basically the same as those in Lee and Lee (2015).

  8. As discussed before, with respect to Fig. 10, the inverse U-shaped curve of the wealth difference becomes clear if we increase the size of the population.

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Acknowledgements

Earlier versions of this paper were presented on several occasions, such as at the Seoul National University—Institute for Research in Finance and Economics in October 2017, the IEFS-EAER conference in September 2016, and the International Workshop on Computational Economics and Econometrics in July 2016. The authors thank the editor and two anonymous referees of this journal for their valuable insights. The second author acknowledges the funding from the Basic Research Program of the National Research University Higher School of Economics and the Russian Academic Excellence Project 5-100.

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Authors and Affiliations

  1. Korea Military Academy, Seoul, Korea

    Sunyoung Lee

  2. Seoul National University, Seoul, Korea

    Keun Lee

  3. Institute for Statistical Studies and Economics of Knowledge of the National Research University Higher School of Economics, Moscow, Russia

    Keun Lee

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  1. Sunyoung Lee
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  2. Keun Lee
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Correspondence to Keun Lee.

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Lee, S., Lee, K. 3% rules the market: herding behavior of a group of investors, asset market volatility, and return to the group in an agent-based model. J Econ Interact Coord 16, 359–380 (2021). https://doi.org/10.1007/s11403-020-00299-x

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