Herd behavior in the Baltic equity markets during the COVID-19 pandemic

Abstract

Herd behavior has been extensively studied, with contradictory results regarding its existence in different market situations. Herding is a behavioral bias that causes humans to follow each other’s actions without perfectly evaluating the reasons or motivations for them. It is derived from animals and, therefore, embedded in our DNA, making it difficult to overcome.

Herding poses challenges to fundamental finance theories as it can stem from irrational behav-ior. For instance, asset pricing models, such as the Capital Asset Pricing Model, rely on the as-sumption of a perfect capital market, which entails that financial agents are rational self-utility maximizers. Prior literature shows that herding can lead to stock market bubbles and other tem-porary market inefficiencies, which directly contradict the Efficient Market Hypothesis.

This thesis aims to assess whether herd behavior can be noticed in the Baltic equity markets during a global pandemic, namely the recent Coronavirus disease (COVID-19) pandemic. The sample period of this thesis is divided into three sub-periods: the pre-COVID period, the COVID period, and the post-COVID period, which are studied separately alongside the entire sample period. Additionally, this thesis reviews fundamental finance theories closely associated with herding and how such bias may affect them. To add context to the empirical results, previous literature related to herd behavior in stock markets is discussed.

The methodology of this thesis is based on a regression analysis that uses stock return disper-sions to determine whether market-wide herding can be observed. This thesis employs the cross-sectional absolute deviation model, which was introduced by Chang et al. (2000) and is a more advanced version of the cross-sectional standard deviation model introduced by Christie and Huang (1995).

All three suggested hypotheses can be rejected based on the empirical results obtained from the Baltic equity markets. Estonia is the only country that exhibits herd behavior, but only during pre-pandemic and post-pandemic periods. The results, however, are not statistically significant, and therefore, they can be seen as inconclusive. Lithuania, however, produces evidence of anti-herding behavior during the pre-pandemic period that is significant at a 5% level. This implies that investors acted rationally regarding herd behavior in Lithuania before the pandemic.