How Herd behaviour in stock market could compound investors' financial woes

The stock market has been conventionally viewed as a leading indicator or predictor of future economic activity. Stock price indices are expected to reflect market participants' rational information expectations of discounted future earnings attributable to investment effect, wealth effect, and consumption effect. 

However, the quick run-up in Indian equities in recent months tends to raise concerns over the rational information expectations of market participants. Since their March 2020 low (Sensex: 25981.24, Nifty: 7610.25), the benchmark market indices of BSE Sensex (52,386.19) and Nifty 50 (15,689.80) witnessed more than 100% growth. 

This trend is alarming enough as the country has grappled with the worst health crisis ever with lower growth forecasts and Indian equities have climbed to record levels.

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Even though the Reserve Bank of India (RBI) has lowered the gross domestic product (GDP) growth projections for FY22 to 9.5 from the earlier forecast of 10.5% due to the COVID-19 second wave, there is no sign of change in the upward trajectory of benchmark indices. 

The dramatic increase in the second wave of COVID-19 infections since February 2021 has brought the Indian economy to a near standstill, and further weakened its nascent recovery. 

International rating agencies like JP Morgan, Moody's, and Barclays have also placed their GDP growth projections for India for FY22 below 10%. Amidst the recent bull run with strong recovery expectations, while informally, the common question among investment professionals these days is whether the Indian equity market is overvalued.

On the sidelines of all the good news about the market movement, the magnitude of gains in the benchmark equity indices perhaps indicates a bull trap in an overvalued market. 

One of the reasons for such a recent bull run in the Indian equity market may be 'Herding Behavior'. Typically, investors' herd behavior can be characterised by the irrational tendency of individuals to follow others and imitate group behaviors even if their private information suggests something different. 

Investors' propensity to herd in a financial market can be expressed in various forms such as trading in the same direction as others, following past price trends, momentum investing or positive-feedback strategies, and imitating others' behavior. 

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One of the commonly used approaches to quantify the same is through the Cross-Sectional Absolute Deviation (CSAD), which is a mathematical equation that explains the extent to which stock returns are converging towards market returns. 

The lower the value of this measure, i.e., less dispersion, the higher the degree of herd behavior in the market, and vice-versa. Figure 1 presents the time series CSAD of NSE Nifty and BSE Sensex over January 2020 to July 2021. 

The values suggest that in March 2020, during the first wave of COVID-19, the CSAD measures of Sensex and Nifty were at an all-time high, 2.20 and 2.15, respectively. 

Incidentally, this period coincides with the downward trend in benchmark market indices. Through the early stage of COVID-19 spread, the Sensex and Nifty tanked close to 40% from the level of  42,000 and 12,000, respectively.

However, since the beginning of 2021, when Sensex and Nifty recorded their best performances and surged to 52488 and 15722, respectively, CSAD is at an all-time low (0.23 and 0.28, respectively). Moreover, there is a continuing divergence between CSAD and benchmark market indices since June 2020 which resounds the bull-run period of Indian equities.

As mentioned, behavioral finance theories suggest that investors tend to echo other investors' actions by ignoring their private information due to herding phenomena. 

One may argue that it takes time for market participants to assimilate and act on new information thoroughly, and thus, market prices fully reflect further information only over time. 

However, investors can observe each other's actions but not the private information or signals that each market player receives. Economic theory suggests that even in such a scenario, the information contained in the decisions made by others makes each person's decision less responsive to her input and hence less informative to others. 

This can generate instability in equity markets, lead to speculative episodes of bull runs and add to volatility. 
 
The Reasons 

Sentiment Effect: One of the reasons for such high herding in the Indian stock market could be the investors' collective cognitive bias called the sentient effect. 

Figure 2 presents the movement of NSE VIX or volatility index with the benchmark market indices. VIX, or the investor fear gauge or market uncertainty measure reflects pessimism (optimism) with an upward (downward) trend. 

VIX index appears to be at its all-time low (13.36) since its peak of 83.61 in March 2020. A lower VIX (below 20 levels) with CSAD measures moving concurrently indicates that the bulls may have the upper hand in the market with persistent herding. 

Even if India's real GDP shrank by a record 7.3% in FY21, India's total market capitalisation as a percentage of GDP achieved an all-time high of 115% during June 2021. 

It stands close to its all-time high valuations of 150% during the 2008 market crash. Such high valuations amid the contraction of real GDP due to pandemic uncertainties are inconsistent with fundamental valuations and rational expectations. 

Herding behavior is more prominent under circumstances of elevated uncertainty. In such a market scenario to reduce their risk exposure and minimise market uncertainty, investors prefer to join the crowd. 

Greater sentiment-driven traders in the market during high sentiment periods tend to undermine an otherwise positive mean-variance trade-off. Since investors value gains and losses differently due to cognitive bias, investor risk aversion increases during a pessimistic market environment. 

Positive (negative) sentiment reduces (increases) risk aversion. Herding is expected to be more evident when the VIX decreases. Since sentiment traders undermine the mean-variance relation during the optimistic period, macroeconomic variables containing business cycle information have far less ability than investor sentiment to distinguish the high and low mean-variance tradeoff regimes. 

This is perhaps the reason why everyone is concerned with the severe collapse in projected growth recovery amid the second wave, and domestic equities are still upswing. When risk aversion is low (optimism is high), investors are more likely to extrapolate recent good news (price trends) and ignore future bad news. Thus, investor herding inequities may be a result of an irrational but systematic response to investor sentiment.  

Household Wealth Effect: RBI data shows that the household financial savings are estimated to have increased sharply during 2020-21. According to the data, in the fortnight ending June 18, the currency with the public further increased to hit a new high of Rs 28 lakh crore. 

The demand for deposits with banks declined from close to 20 lakh crore to 18 lakh crore. The significant increase in household financial assets and moderation in household financial liabilities led to a rise in household financial savings in Q1:2020-21, and a substantial part of it was directed towards Mutual Funds. 

As per the Association of Mutual Funds in India (AMFI) newsletter, funds mobilised (INR in crore) for June 2021 amount to Rs 10,25,98,906 as compared to Rs 6,47,286.77 for  January 2021.

Further, NSDL reports that Indian investors have opened a record 14.2 million new Demat accounts in FY21 (4.9 million in the FY20, and the three-year average is 4.5 million). Data released from NSE indicates that individual investors' trading accounts for 45% in 2021. 

A recent report by the foreign brokerage firm UBS notes, "Overall when we combine household equity savings through mutual funds and direct share purchase, we see that households are a material force to be reckoned with overall 25 % higher than foreign portfolio investment net inflows". 

Apart from retail investors, Foreign Institutional Investors (FIIs) in fiscal 2020-21 invested more than Rs 2.75 lakh crore in the Indian stock markets, the highest in the last two decades. However, despite FII'S selling pressure in April and May, the stock market continued its northward movement due to retail buying directly and via mutual funds. 

Investors should thus be careful while betting big on such an overvalued market. Such overvalued equity market phenomena due to the herding effect is a significant factual issue because of the apparent negative wealth effect on individual investors' portfolios and the aggregate market instability risk. 

Persistent bull-run due to herding and systematic mispricing in the market could result in substantial resource misallocation in the economy and compound financial woes. 

In the current state of the economy with a booming market, if aggregate wealth fluctuations can be very large relative to household income, consumer spending, and GDP forecast, the potential impact of the negative wealth effect in the event of a market crash could be devastating. 

(Prof. Saumya Ranjan Dash, Faculty, IIM Indore & FPM Participant Garima Goel on Indian Stock Market.)