Author(s): Madhuri Prabhakar and Sameer Varma
Stock market crashes and bubbles are complex events influenced by rational and irrational forces. Herding and overconfidence are strong behavioral biases inducing unwarranted market movements. Overconfident investors exaggerate their competence, forecasting prowess, and ability to outperform the market, leading to risk-taking, high leverage, and mispricing of securities. Herding behavior forces investors to mimic others' moves rather than perform independent analysis, thereby increasing speculative cycles and market inefficiencies. All these biases collectively create unsustainable asset price inflation, leading to large corrections and financial crises. This study analyzes the theoretical foundations of overconfidence and herding, evaluating their effects on the basis of empirical evidence from major financial bubbles and crashes like the Dot-com Bubble and the 2008 Financial Crisis. The evidence points towards greater investor sophistication, behavioral risk management, and policy measures to mitigate the adverse effects of these biases in financial markets.