Measuring and Managing herd behavior in financial markets

“Diversify” is the commonly heard advice for investing on the stock market. Don’t put all your eggs in one basket. It makes sense, but sometimes, during financial downturns, especially, stock prices can begin moving together—and cancel the effect of diversification, right when you need it most! This phenomenon of prices moving en masse is called herd behavior and the stronger it is, the more dangerous for the investor. Daniël Linders plans to develop a new methodology which can be used as a nearly real-time measure of connectedness in the market and, thus, of financial risk.
Current methods for predicting future co-movements between stock prices rely on extrapolating from past data, but this can only work when the past and the future resemble each other. Dr. Linders approaches it differently. Instead of relying on a particular theoretical model or figures from the past, he will make use of the current prices at which stocks and options are trading and measure herd behavior in a model-free way. By calculating the degree of herd behavior daily—for specific countries or sectors or a portfolio of stocks—he hopes to provide information that can be used to adjust stock market trading strategies. Understanding the level of connectedness in the market could let everyone involved take the necessary precautions and avoid a cascade of troubles the next time the market goes south.