Exploring Herding Instincts Through the Lens of Adaptive Market Hypothesis: Insights from a Frontier Market

This study examines the time-varying nature of investor herd behavior over different market episodes in Sri Lankan stock market, that has been subjected to convulsed periods such as civil war, political instability, terrorist attacks and COVID-19 pandemic. The study employs Cross-Sectional Absolute Deviation methodology, applying quantile regression approach, to detect aggregate level herding using a survivorship-bias-free dataset of daily firm level returns from April 2000 to March 2022. The dataset is subdivided into market episodes corresponding to pre-war, bubble, crash, post-crash, pre-COVID crash, COVID bubble and post-COVID crash periods. Exhibiting an evolutionary herding pattern over market episodes, the results depict that herding appears in pre-war period irrespective of the market directions, persisting in bubble episode in upmarket days, which then, turning into negative herding in down market days in crash episode. Subsequently, herding gradually disappears in post-crash episode, reappears with greater intensity in pre-COVID crash episode and disappears in COVID bubble and post-COVID crash episodes. This study attributes such wax and wane nature of herding in financial markets to a survival action, a rational heuristic, in keeping with Adaptive Market Hypothesis. The study is of peculiar importance to investors, policymakers, regulators and researchers, as presence of herding misprices securities and invalidates the existing asset pricing models constructed on the assumptions of investor rationality.