Stochastic Herding by Institutional Investment Managers

This paper demonstrates that the behavior of institutional investors around the downturn of the U.S. equity markets in 2007 is consistent with stochastic herding in attempts to time the market. We consider a model of large number of institutional investment managers who simultaneously decide whether to remain invested in an assets or liquidate their positions. Each fund manager receives imperfect information about the market’s ability to supply liquidity and chooses whether or not to sell the security based on her private information as well as the actions of others. Due to feedback effects the equilibrium is stochastic and the “aggregate action” is characterized by a power-law probability distribution with exponential truncation predicting occasional “explosive” sell-out events. We examine highly disaggregated institutional ownership data of publicly traded stocks to find that stochastic herding explains the underlying data generating mechanism. Furthermore, consistent with market-timing considerations, the distribution parameter measuring the degree of herding rises sharply immediately prior the sell-out phase. The sell-out phase is consistent with the transition from subcritical to supercritical phase, whereby the system swings sharply to a new equilibrium. Specifically, exponential truncation vanishes as the distribution of fund manager actions becomes centered around the same action – all sell. JEL classification codes: D8, G2, G14 ∗We are grateful for the support from the Research Center for Price Dynamics funded by a JSPS Grant-in-Aid for Creative Scientific Research (18GS0101). †The authors would like to thank Theodoros Stamatiou and the participants of the University of California Santa Cruz Economics Department Seminar for their comments and suggestions.