The Effect of Liquidity on Herding: A Comparative Study

Abstract

This paper provides original evidence on the relation between herd behavior and equity market liquidity, an issue that has been neglected when studying herd behavior towards the consensus. We use equity price data for the G5 markets, and initially we find no evidence of herding. When, however, we condition on the daily liquidity of stocks we find significant evidence of herd behavior for days with high or medium stock liquidity, for all countries and the majority of the sub-periods. The only exception is Germany for which there is very weak evidence of herding. Variance decomposition tests indicate that the variance of the average equity market liquidity is affected by return clustering, especially during the crisis and post-crisis period and this effect is more pronounced for the US market.