An Investigation into the Factors Influencing Herd Formation by Investors in the Nairobi Securities Exchange: A Behavioural Finance Approach

Abstract

The Efficient Market Hypothesis (EMH) and the rational expectation theories which are standard (traditional) finance theories explain the happenings in the stock markets using models in which the investors are rational and how stock prices reflect the available information in the market. However, there are instances where stock markets go contrary to this explanation, due to other factors, thus leading to market imperfections such as herd formation. This study sought to investigate the factors that influence herd formation by individual investors in the Nairobi Securities Exchange (NSE). A sample of 100 respondents within Nairobi County was used. The respondents were selected using simple random sampling. Primary data was gathered using questionnaires and personal interviews. Secondary data was acquired through reviewing of journals, annual reports, newspapers, relevant websites, newsletters and other relevant literature on the study under investigation. Data was analyzed qualitatively and quantitatively with the assistance of the Statistical Package for Social Sciences (SPSS). Literature review shows that market imperfections that are contrary to traditional finance theories are best explained by the new branch of finance (behavioural finance) which incorporates the psychological mechanisms of individuals in making of investment decisions. Behavioural finance outlines behavioural aspects such as loss aversion, contrarian behaviour, overconfidence, cognitive dissonance, cognitive heuristics, self deception, representativeness, anchoring, behavioural biases and herd formation portrayed by individual investors as examples of such imperfections. These behaviours in turn influence the trend in the stock market. The study found out that herding or herd formation is one of the behavioural aspects prevalent in the NSE. The factors influencing herd formation are social pressure of conformity to a group, market announcements and the political environment. However, technology though an important factor in share trading does not influence herd formation in the NSE. There is therefore need for the government, investors, NSE, Capital Markets Authority (CMA), learning institutions and other market players to understand the market dynamics and look more closely at factors other than price that influence the performance of the stock market and enact well designed strategies on the efficient operation and management of the stock market in Kenya.