Research in International Business and Finance 68 (2024) 102163

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Research in International Business and Finance

journal homepage: www.elsevier.com/locate/ribaf

Full length article

Herding states and stock market returns✩

Filipe Costa ∗, Natércia Fortuna, Júlio Lobão
CEF.UP, School of Economics and Management, University of Porto, Portugal, Rua Dr. Roberto Frias, 4200-464, Porto, Portugal

ARTICLE INFO ABSTRACT

JEL classification: This paper investigates whether herd behaviour states (intense/adverse) affect stock market
G40 returns using a fixed effects model to capture cross-sectional and time variability covering the
G12 European region. We show that stock market returns depend on past herding states. From
G15
December 1992 to December 2020, the mean returns following an intense herding state are
C32
0.26% lower per month over a six-month holding period than following an adverse herding
Keywords: state. Our results are robust to using risk-adjusted returns and a continuous herding variable.
Herding behaviour
We also show that intense herding emerges during periods of lower returns and higher volatility
Cross-sectional dispersion of stock returns
than adverse herding.
European equity markets
State–space models

1. Introduction

Several studies report herd behaviour and its persistence in the stock market (Hwang and Salmon, 2004; Chiang and Zheng,
2010; Mobarek et al., 2014; Indärs et al., 2019). Less is known about the impact of herd behaviour on future market returns. To
fill the literature gap, we examine whether conditioning on the state of beta herding brings about a significant impact in aggregate
market returns internationally in 16 European countries, by regressing aggregate market returns on past herding states. The main
contribution is to show that stock market returns are markedly dependent on past herding states.
Our empirical evidence indicates that excess market returns are significantly lower following periods of intense herding behaviour
than adverse herding, suggesting overpricing. The mean excess market returns following an intense herding state are, on average,
0.26% lower per month over a six-month holding period than following an adverse herding state. We find that the return spread
conditional on herding states dissipates over time, but it is statistically significant for holding periods of up to 18 months. These
results are robust to benchmark-adjusted returns using the CAPM and the five-factor Fama–French model (Fama and French, 2015)
augmented by the momentum factor (Carhart, 1997). Moreover, the results from regressing excess market returns on a lagged
herding variable show a strong negative relationship, further supporting an inference that herd behaviour generates overpricing at
the market level. Our results support the evidence from Hwang et al. (2021) on the impact of past herding states on market returns
but contrast with them in finding that intense herding emerges during periods of lower returns and higher volatility than adverse
herding, and not the opposite.
This study adds to an extensive body of research documenting stock returns’ predictability (Jegadeesh and Titman, 1993; Pesaran
and Timmermann, 1995; Edmans et al., 2007; Schmeling, 2009) and their state dependency (Cooper et al., 2004; Conrad and
Yavuz, 2016; Li and Galvani, 2018). The strong negative relationship between past herding states and market returns is consistent
with the literature on overpricing and overreaction (Barberis et al., 1998; Daniel et al., 1998). Our study is part of the literature

✩ This research has been financed by Portuguese public funds through FCT - Fundação para a Ciência e a Tecnologia, I.P., in the framework of the project
with reference UIDB/04105/2020.
∗ Corresponding author.
E-mail address: fcosta@l13.pt (F. Costa).

https://doi.org/10.1016/j.ribaf.2023.102163
Received 15 December 2022; Received in revised form 7 August 2023; Accepted 29 October 2023
Available online 4 November 2023
0275-5319/© 2023 The Author(s). Published by Elsevier B.V. This is an open access article under the CC BY license
(http://creativecommons.org/licenses/by/4.0/).
F. Costa et al. Research in International Business and Finance 68 (2024) 102163

that investigates the asset pricing impact of behavioural biases documented in psychology research, comprehensively reviewed
by Hirshleifer (2001) and Shiller (2016). The strand of the research closest to our paper investigates the existence and persistence
of herd behaviour in the stock market (Chang et al., 2000; Hwang and Salmon, 2004; Demirer and Kutan, 2006; Tan et al., 2008).
The remainder of this paper is structured as follows. The next section selectively reviews the existing literature. Section 3
describes the data and the methodology. Section 4 provides descriptive statistics and discusses the estimation results. Section 5
concludes the paper.

2. Literature review

In its semi-strong form, the efficient market hypothesis has been challenged in recent decades. Several studies provide evidence
of anomalous behaviour leading to persistent bias from the results predicted by rational models. For instance, the presence of herd
behaviour, defined as the suppression of investors’ own beliefs to follow the collective movements of the market, is documented in
studies for both developed markets (Mobarek et al., 2014; Galariotis et al., 2015; Bekiros et al., 2017) and emerging markets (Tan
et al., 2008; Demirer et al., 2010; Arjoon and Bhatnagar, 2017; Guney et al., 2017). Moreover, this intentional herd behaviour
is reported to be conditional on up and down states for market returns (Chiang and Zheng, 2010; Qiao et al., 2014; Economou
et al., 2016; Indärs et al., 2019), volatility (Tan et al., 2008; Gavriilidis et al., 2013; Guney et al., 2017), liquidity (Yao et al., 2014;
Lam and Qiao, 2015; Economou et al., 2016) and sentiment (Gavriilidis et al., 2016; Economou et al., 2018; Aharon, 2021). Such
evidence represents a distortion in fundamental values, suggesting market inefficiency through persistent mispricing.
Research on herd behaviour can be split into two major groups. The first group focus on individual assets and the behaviour of a
small group of investors, capturing herding from the trading activity of these investors, their portfolio changes, and individual assets
trading data (Lakonishok et al., 1992; Grinblatt et al., 1995; Wermers, 1999). The second group captures herding as a collective
movement towards a market-level consensus and relies on aggregate market data (Christie and Huang, 1995; Chang et al., 2000;
Hwang and Salmon, 2004). Our research captures herding behaviour in the time-varying state–space framework of the Hwang and
Salmon’s 2004 model. Our focus is beta herding, defined as a cross-sectional compression of factor betas towards their respective
means. Since herding must revert at some point, the opposite behaviour, adverse herding, under which the factor betas are dispersed
away from their mean, is also possible.
Hwang et al. (2021) argue that what causes beta herding is a well-known behavioural bias, investor overconfidence, defined
as investors’ biased perceptions about the precision of their signals as defined in Daniel et al. (1998). The bias in betas reflects
the behaviour of investors that herd towards the performance of the market portfolio (or other factors/style portfolios), increasing
during tranquil and low volatility periods. Beta herding is sometimes persistent (Yao et al., 2014; Messis and Zapranis, 2014; Bekiros
et al., 2017) because movements in investors’ sentiment and emotions are unpredictable, preventing risk-neutral arbitrageurs from
betting against mispricing (Shleifer and Vishny, 1997; De Long et al., 1990).
Hirshleifer (2001) attributes the source of behavioural biases to the limitations of cognitive resources, leading to heuristic simplifi-
cation. Judgements requiring heuristic or substantive processing are also more likely to be infused by affect (Forgas, 1995). Tversky
and Kahneman (1991) predict that losses and disadvantages impact preferences more than gains and advantages. Tversky and
Kahneman (1974) claim that an individual’s decisions are influenced by a reference point or anchor, from which adjustments are
subsequently made. It follows from the literature that herd behaviour may be more prominent under circumstances of elevated
uncertainty when investors are overwhelmed with complex information and follow the performance of the market to reduce their
risk exposure (Aharon, 2021). Market performance is a readily-available piece of information (anchor) that investors may use as
a shortcut for complex investment decisions, particularly during turbulent periods when the market is loaded with uncertainty and
risk. Herding may result from an anchoring bias, leading to underpricing of high beta stocks (underreaction to new information)
and overpricing of low beta stocks (overreaction) as betas become compressed towards the market consensus. Both Daniel et al.
(1998) and Barberis et al. (1998) reconcile the empirical findings of overreaction and underreaction, but the psychological factors
underpinning their models are different.
There is ample evidence of herd behaviour being conditional on market states, changing with market returns, uncertainty and
trading conditions, sometimes leading to significant mispricing. Hence one may ask whether the reversion of extreme herd behaviour
impacts future market conditions; that is, does herd behaviour affect market returns? Does past extreme herd behaviour condition
current stock returns?
Venezia et al. (2011) study herd behaviour by professional and amateur investors and find that herding, in the form of buy
imbalances, may predict market returns. They find some evidence of a correlation between lagged herding and market returns, but
their study aims to distinguish the factors affecting herd behaviour by professionals and amateurs, and they do not address whether
herd behaviour can impact future returns directly. Blasco et al. (2012) find strong signs of causality from return performance to
herding intensity but not in the inverse direction. However, their study focuses on a single market (Spain) for a limited period
between 1997 and 2003. Moreover, Granger’s causality tests cannot reject that herding intensity does not cause returns, which is not
a confirmation of an absence of relationships in that direction. Hwang et al. (2021) show that the risk-adjusted return of high minus
low standardised-beta portfolios over 12 months is significantly negative following adverse beta herding, with the difference in the
results conditional upon intense herding being significant at the 5% level. Their presented evidence also shows significantly positive
risk-adjusted returns across beta deciles conditional on adverse herding, suggesting that risk-adjusted returns for the subsequent 12
months after portfolio formation may be higher after a period of adverse herding than intense herding. Notwithstanding, their focus
is on explaining the low-beta anomaly and not on the impact of past extreme herding states on aggregate-level market returns.

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

To fill the literature gap, we investigate whether aggregate-level market returns are conditional on past beta herding states, by
regressing market returns on lagged herding states. We estimate herding time series for European countries and use the quintiles of
the distributions to identify three herding states: intense herding (INT) corresponding to the upper quintile, adverse herding (ADV)
corresponding to the lower quintile, and neutral herding to capture the middle of the distributions.
We regress market returns on lagged herding time series to check robustness. The main advantage of using dichotomous variables
compared with a continuous variable is that the former identifies a sudden change in herd behaviour but at the expense of the
number of observed signals being lower, which reduces statistical power. However, to improve the statistical power of the results
and to yield more reliable estimates, we use a panel dataset covering observations across 16 countries (see, e.g. Hsiao (2007) for a
discussion of the advantages of panel data).
Our foremost contribution consists in showing that aggregate-level market returns are markedly dependent on past beta herding
states, hence extending the herd behaviour literature and adding evidence to a growing body of research on asset mispricing. We
expand our study to address whether herding arises during tranquil or turbulent periods, which has been the focus of considerable
divergence in the literature. Our results show that around periods of intense herding, market returns are lower, and the standard
deviation of market returns is higher than around periods of adverse herding, aligning with the general findings of the behavioural
theory predicting the presence of common biases resulting from intuitive judgements under uncertainty (Tversky and Kahneman,
1974)

3. Data and methodology

3.1. Sample selection

Our empirical analysis relies on data from Thomson Datastream (TDS) international database for the period spanning from
December 1992 to December 2020. It covers the 16 European countries that are part of the European region as in the Fama–
French factor returns: Austria, Belgium, Switzerland, Germany, Denmark, Spain, Finland, France, the UK, Greece, Ireland, Italy, the
Netherlands, Norway, Portugal and Sweden. We collect monthly return index (RI) and market capitalisation (MV) data for all stocks
with a primary listing in national exchanges, selecting the data separately by country. To avoid survival bias, we do not exclude any
equities de-listed in the period. The sample covers 20,669 stocks and 1,932,614 return observations. We collect the above data in
US dollars to be consistent with the literature on international asset pricing (e.g. Fama and French, 2012, 2017) and to deal with
the problem of different currency denominations in Europe. To minimise the impact of suspicious observations, large changes in
small stocks and extreme observations reported in Ince and Porter (2006), De Moor and Sercu (2013), we dismiss all observations
with either RI or MV missing, all stocks with mean market capitalisation below $25 million and less than 24 monthly observations
and winsorise the data at 99.5%. The final dataset is composed of 9534 stocks and 1,442,315 observations. The impact of the filters
on the mean total market capitalisation is minimal, declining from $9.17 trillion to $9.13 trillion.
The data for the European factors size (SMB), value (HML), operating profitability (RMW), investment (CMA), momentum (WML),
and the US one-month Treasury bill rate are obtained from Kenneth French’s website at Dartmouth College.1

3.2. Factor models

To capture the patterns in average returns, we use the one-factor CAPM (Sharpe, 1964; Lintner, 1965) and a six-factor model
(henceforth, FF5F+) that expands the Fama–French five-factor model (Fama and French, 2015) to capture momentum (Carhart,
1997). In their empirical forms, the CAPM and the FF5F+ model can be described as follows:
( )
𝐶𝐴𝑃 𝑀 ∶ 𝑅𝑖𝑡 − 𝑅𝐹𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 𝑅𝑚𝑡 − 𝑅𝐹𝑡 + 𝜀𝑖𝑡 , (3.1)

( )
𝐹 𝐹 5𝐹 + ∶ 𝑅𝑖𝑡 − 𝑅𝐹𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 𝑅𝑚𝑡 − 𝑅𝐹𝑡 + 𝛽𝑖𝑠 𝑆𝑀𝐵𝑡 + 𝛽𝑖ℎ 𝐻𝑀𝐿𝑡 (3.2)
+ 𝛽𝑖𝑟 𝑅𝑀𝑊𝑡 + 𝛽𝑖𝑐 𝐶𝑀𝐴𝑡 + 𝛽𝑖𝑤 𝑊 𝑀𝐿𝑡 + 𝜀𝑖𝑡 .

In the above equations, 𝑅𝑖 is the return on asset 𝑖 for month 𝑡, 𝑅𝐹𝑡 is the risk-free rate, 𝑅𝑚𝑡 is the return on the market portfolio, 𝑆𝑀𝐵𝑡
is the return on diversified portfolios of small stocks minus big stocks, 𝐻𝑀𝐿𝑡 is the difference between the returns on diversified
portfolios of high and low B/M stocks, 𝑅𝑀𝑊𝑡 is the difference between the returns on diversified portfolios of stocks with robust
and weak profitability, 𝐶𝑀𝐴𝑡 is the difference between the returns on diversified portfolios of the stocks of low (conservative) and
high (aggressive) investment firms, 𝑊 𝑀𝐿𝑡 is the difference between the returns on diversified portfolios of the winners and losers
of the past twelve months, and 𝜀𝑖𝑡 is a zero-mean error term. The coefficients 𝛽𝑖𝑚 , 𝛽𝑖𝑠 , 𝛽𝑖ℎ , 𝛽𝑖𝑟 , 𝛽𝑖𝑐 and 𝛽𝑖𝑤 capture the exposure of
asset 𝑖 to each factor. Country subscripts are omitted for simplicity.
Some of the markets in our dataset are not large enough to extract efficient factor portfolios. We opt to obtain data for the SMB,
HML, RMW, CMA and WML factors at the European level and the market factor at the country level. Excess market returns are
the difference between the value-weighted market index minus the US one-month Treasury bill rate. The choice of a risk-free rate
coincides with the Fama–French calculation of global factors (Fama and French, 2012).

1 Retrieved 30 June 2021, from https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

To capture the time series of herding towards the market for each country, we use the FF5F+ model with country-level excess
market returns and European-level returns for the other factors. To capture the risk-adjusted returns, we use the CAPM and the
FF5F+ model, but with all factors obtained at the European level.2 We estimate the regression coefficients of Eqs. (3.1) and (3.2)
using the least absolute deviation (LAD) with robust standard errors, a particular case of the quantile regression on the median that
is robust to outliers (Koenker and Bassett, 1978), using a rolling regression with a window size of 24 observations, to account for
time variation in betas. The choice of a small interval allows us to better capture the time-varying dynamics of alphas and betas.

3.3. Herding measurement

We apply the state–space methodology of Hwang and Salmon (2004) to obtain herding series towards the market factor at
the country level. These series are used to determine the herding state dummies used as independent variables in our panel
regressions. Hwang and Salmon (2004) focus on beta herding, identifying it as a reduction in the cross-sectional dispersion of
factor sensitivities (betas). They claim that when there is herding towards the market portfolio, investors only consider the value of
individual assets after forming a market view. They assume that investors’ behaviour is conditional on the expected return for the
market portfolio, at least in the short term, leading to biased expected returns and betas for individual assets. The biased market
𝑏 , is the result of distortion induced by a latent herding parameter, ℎ , on the true beta, 𝛽 ,
beta, 𝛽𝑖𝑚𝑡 𝑚𝑡 𝑖𝑚𝑡

𝑏
( )
𝛽𝑖𝑚𝑡 = 𝛽𝑖𝑚𝑡 − ℎ𝑚𝑡 (𝛽𝑖𝑚𝑡 − 𝐸𝑐 𝛽𝑖𝑚𝑡 ), (3.3)
( )
where 𝐸𝑐 𝛽𝑖𝑚𝑡 is the cross-sectional expected market beta at time 𝑡. When ℎ𝑚𝑡 = 0, there is no herding towards the market and
𝑏 = 𝛽 . Otherwise, if ℎ
𝛽𝑖𝑚𝑡 𝑖𝑚𝑡 𝑚𝑡 > 0, there is some degree of herding towards the market and if ℎ𝑚𝑡 < 0, there is adverse herding (an
eventual return to fundamentals). The cross-sectional standard deviation of betas can be measured as:
√ [
( 𝑏 ) ( ( ( )) ( 𝑏 ))2 ] ( )( )
𝑆𝑡𝑑𝑐 𝛽𝑖𝑚𝑡 = 𝐸𝑐 𝛽𝑖𝑚𝑡 − ℎ𝑘𝑡 𝛽𝑖𝑚𝑡 − 𝐸𝑐 𝛽𝑖𝑚𝑡 − 𝐸𝑐 𝛽𝑖𝑚𝑡 = 𝑆𝑡𝑑𝑐 𝛽𝑖𝑚𝑡 1 − ℎ𝑚𝑡 , (3.4)

where 𝐸𝑐 (.) and 𝑆𝑡𝑑𝑐 (.) represent the cross-sectional expectation and standard deviation, respectively. After estimating 𝛽̂𝑖𝑚𝑡
𝑏 , we obtain

the cross-sectional standard deviation of the market betas as,

√
√ ( )2
√
( ) √ √∑ 𝑁 𝑤𝑖𝑡 𝛽̂𝑏 − 𝛽̂𝑏
𝑖𝑚𝑡 𝑖𝑚𝑡
̂
𝑆𝑡𝑑𝑐 𝛽̂𝑖𝑚𝑡 = √
𝑏 , (3.5)
𝑁−1
𝑖=1 𝑁

𝑏 = ∑𝑁𝑡 𝑤 𝛽̂𝑏 , 𝑁 is the number of stocks trading in month 𝑡 − 1 with a beta observation at time 𝑡, and 𝑤 is the weight
where 𝛽̂𝑖𝑚𝑡 𝑖=1 𝑖𝑡 𝑖𝑚𝑡 𝑖𝑡
given to stock 𝑖 at time 𝑡. We opt for the value-weighted instead of the equal-weighted dispersion of betas to minimise the impact
of small stocks in the herding measure. After proceeding to a natural logarithm transformation, Eq. (3.4) becomes:
[ ( 𝑏 )] [ ( )] ( )
𝑙𝑛 𝑆𝑡𝑑𝑐 𝛽𝑖𝑚𝑡 = 𝑙𝑛 𝑆𝑡𝑑𝑐 𝛽𝑖𝑚𝑡 + 𝑙𝑛 1 − ℎ𝑚𝑡 . (3.6)

We rewrite the model into state–space notation and extract the time series of herding at the country level from the following
measurement and state equations,
[ ( 𝑏 )]
𝑙𝑛 𝑆𝑡𝑑𝑐 𝛽𝑖𝑚𝑡 = 𝜇𝑚 + 𝐻𝑚𝑡 + 𝜈𝑚𝑡 , (3.7)

𝐻𝑚𝑡 = 𝜙𝑚 𝐻𝑚𝑡−1 + 𝜂𝑚𝑡 , (3.8)

( 𝑏 )
where 𝑆𝑡𝑑𝑐 𝛽𝑖𝑚𝑡 is the cross-sectional standard deviation of biased market betas at time 𝑡, 𝐻𝑚𝑡 is the herding
( effect
) evolving over
{ [ ( )]} ( 2
) 2
time, which follows a mean zero AR(1) process, 𝜇𝑚𝑡 = 𝐸 𝑙𝑛 𝑆𝑡𝑑𝑐 𝛽𝑖𝑚𝑡 , 𝜈𝑚𝑡 ∼ 𝑖𝑖𝑑 0, 𝜎𝑚𝜈 and 𝜂𝑚𝑡 ∼ 𝑖𝑖𝑑 0, 𝜎𝑚𝜂 . We estimate the
model and extract the time series of herding at the country level using a smoothed Kalman filter. The herding variables for each
country are obtained as follows:

𝐻𝐸𝑅𝐷𝑚𝑡 = 𝑒𝐻𝑚𝑡 . (3.9)

3.3.1. Herding states and holding period returns

To examine the performance of market portfolios at the country level conditioning on the state of herd behaviour, we define
two states: (1) ‘INT’ (intense) and (2) ‘ADV’ (adverse). A month 𝑡 is in the INT (ADV) herding state if the herding time series at
the country level is in the upper (lower) quintile.3 To capture the influence of the herding state over time, we obtain returns for
48 holding periods, from (𝑡, 𝑡 + 1) to (𝑡, 𝑡 + 48) in increasing intervals of one month. Such a large number of event windows gives
robustness to the results. Moreover, the increasing lengths of the event windows allow us to better capture response speeds and

2 Since we are adjusting country portfolios that correspond to a market portfolio for that particular country, we cannot use these portfolios at the right-hand

side of a factor adjustment model. For this reason, we use the European market factor for risk adjustment.
3 We also attempted different settings to define INT and ADV herding, using the 25th and 30th percentiles and find no significant changes in the results.

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

change market trends. We form time series of excess returns (raw returns) and benchmark-adjusted returns using the CAPM and the
FF5F+ model to enhance the results’ robustness further.
To form the benchmark-adjusted returns, we regress the time series of excess market returns for each country on the relevant
risk factors and a constant, following a similar procedure to Cooper et al. (2004). We obtain time series of benchmark-adjusted
returns from the equation:
∑
𝑟𝑎𝑑𝑗
𝑗𝑡 = 𝑟𝑗𝑡 − 𝛽̂𝑖𝑘 𝑓𝑖𝑡 , (3.10)
𝑖

where 𝑟𝑗𝑡 is the realised excess market returns in month 𝑡 for country 𝑗, with 𝑗 = 1, … , 16, 𝑓𝑖𝑡 is the realisation of factor 𝑖 in month 𝑡,
and 𝛽̂𝑖𝑘 is the estimated loading of the time series of excess market returns in month 𝑡 of 𝑓𝑖𝑡 . The obtained benchmark-adjusted returns
correspond to one- and six-factor alphas, capturing the marginal return associated with unit exposure to a given strategy (Jensen,
1968).
The obtained raw and benchmark-adjusted returns are then cumulated and averaged to form the 𝑛-month holding period mean
monthly returns for country 𝑗 at time 𝑡, as follows:
𝑛 ( )
1∑ ∗
𝑅𝑗,𝑛,𝑡 = 𝑟 , (3.11)
𝑛 𝑡=1 𝑗𝑡

where 𝑟∗ is either raw (𝑟𝑗𝑡 ) or benchmark-adjusted (𝑟𝑎𝑑𝑗

𝑗𝑡 ) returns, 𝑛 = 1, … , 48. For instance, the six-month holding period monthly
return in July 2017 consists of the average return observed between January and July of that same year.

3.4. Empirical model

To investigate whether market returns are different when conditioning on the herding state, we evaluate a panel model in which
the market return series, 𝑅𝑛,𝑖𝑡 is a function of the INT herding state and the ADV herding state:
(Model 1)
𝐼𝑁𝑇 𝐴𝐷𝑉
𝑅𝑛,𝑖𝑡 = 𝜙1 𝐷𝑡−𝑛 + 𝜙2 𝐷𝑡−𝑛 + 𝛿𝑖 + 𝜃𝑡 + 𝜖𝑖𝑡 , (3.12)

where 𝑖 represents the country (𝑖 = 1, … , 16), 𝑡 denotes the time period (𝑡 = 1 + 𝑛, … , 290) and 𝑛 is the holding period in months
(𝑛 = 1, … , 48).4 In Model 1, 𝐷𝑡𝐼𝑁𝑇 is a dummy variable taking the value of one if at time 𝑡 herding is in INT state and zero otherwise,
𝐷𝑡𝐴𝐷𝑉 is a dummy variable taking the value of one if at time 𝑡 herding is in ADV state and zero otherwise, 𝛿𝑖 is the cross-sectional
(time-invariant) fixed effects parameter, 𝜃𝑡 is the time series fixed effects parameter, and 𝜖𝑖𝑡 is the error term. Since the 𝑅𝑛,𝑖,𝑡 series use
overlapping observations, we estimate the models with Driscoll and Kraay’s 1998 robust standard errors, setting the number of lags
equal to the number of overlapping months in the holding period window (e.g., five lags for the six-month holding period return
series). A statistically significant 𝜙1 or 𝜙2 embeds the view that herding entails bias in the market outcome, eventually creating
profitable trading strategies.
To test if the mean monthly returns following INT and ADV herding states are equal, we conduct Wald tests on the coefficients for
the herding state dummy variables, 𝐷𝑡−𝑛 𝐼𝑁𝑇 and 𝐷𝐴𝐷𝑉 . We first set two-tailed Wald tests on the null hypothesis that the coefficients
𝑡−𝑛
are equal irrespective of market state:

𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝑣𝑒𝑟𝑠𝑢𝑠 𝐻𝑎 ∶ 𝜙1 − 𝜙2 ≠ 0. (3.13)

A rejection of the null hypothesis supports the alternative hypothesis that the market return is conditional on the past herding state.
We also conduct one-tailed Wald tests to ascertain whether the coefficient associated with one herding state is larger (or smaller)
than the coefficient associated with the other herding state:

𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝑣𝑒𝑟𝑠𝑢𝑠 𝐻𝑎 ∶ 𝜙1 − 𝜙2 < 0, (3.14)

𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝑣𝑒𝑟𝑠𝑢𝑠 𝐻𝑎 ∶ 𝜙1 − 𝜙2 > 0. (3.15)

3.4.1. Empirical model support

The justification for the adoption of a panel methodology is twofold. Firstly, the countries in our dataset are highly integrated in
economic and financial terms making a good case for homogeneous treatment. From this group, 11 countries are part of the Eurozone
and share the same currency,5 seven countries comprise the pan-European Euronext exchange6 and another three countries are part

4 Our data covers 337 stock price observations between December 1992 to December 2020. We lose one observation to estimate stock returns, 23 observations

to estimate herding variables and another 23 observations to estimate benchmark-adjusted returns. The final data has 290 observations.
5 Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal and Spain adopted the euro on 1 January 1999. Greece joined this

group on 1 January 2001.

6 The Euronext was founded in 2000 by the merger of the key stock exchanges of the Netherlands, France and Belgium. Portugal followed in 2001. Ireland,

Norway and Italy joined in 2018, 2019 and 2021, respectively.

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

Table 3.1
Tests for model specification, cross-section dependence, and groupwise heteroskedasticity.
Raw CAPM-adjusted FF5F-adjusted
Panel A - Fixed-effects test
Cross-section 𝐹 statistic 1.62* 10.93*** 27.48***
Period 𝐹 statistic 45.83*** 0.67 0.74

Panel B - Breusch–Pagan LM test of cross-sectional independence

𝜒 2 statistic 2162.39*** 1723.37*** 1090.50***

Panel C - Modified Wald test for groupwise heteroskedasticity

𝜒 2 statistic 4374.66*** 15152.79*** 8935.08***

Notes: This table reports a fixed-effects test (Panel A), the Breush–Pagan LM test of cross-sectional dependence (Panel B), and
the modified Wald test for groupwise heteroskedasticity (Panel C). All tests are conducted on Model 1, described in Eq. (3.12),
for a holding period 𝑛 = 6. ***, ** and * denote statistical significance at the 1%, 5% and 10% levels, respectively.

of the Nasdaq Nordic exchange.7 Secondly, panels contain far more information than single time series, increasing the power of our
tests and allowing us to investigate whether there is a significant herding–return relationship on average across European countries.
To control for time-invariant individual effects that vary across the country, we conduct a fixed-effects model estimation as,
theoretically, we expect some socio-economic and microstructure characteristics to be country-specific and to vary only slowly over
time. We test for redundancy of cross-section and period fixed effects on Model 1, described by Eq. (3.12), for raw and benchmark-
adjusted returns. The results of the tests for an arbitrarily chosen holding period 𝑛 = 6 are presented in Panel A of Table 3.1.8
The null hypothesis of cross-section redundant fixed effects is rejected at the 1% significance level in the three models, and the
null hypothesis of period redundant fixed effects is only rejected (and at the 1% significance level) in the model for raw returns.
According to these results, we specify a model with fixed cross-section and fixed period effects for raw returns and a model with
fixed cross-section effects for CAPM-adjusted and FF5F-adjusted returns.
We test for cross-sectional independence, applying the Lagrange Multiplier test (Breusch and Pagan, 1980), which has the
desirable properties when 𝑇 > 𝑁. We present the results in Panel B of Table 3.1. The null hypothesis of cross-sectional independence
is rejected at the 1% significance level for the three models. We finally conduct a Wald test for groupwise heteroskedasticity modified
for a violation of the normality assumption (Greene, 2000) and present the results on panel C of Table 3.1. The null hypothesis of
homoskedasticity is rejected at the 1% significance level for all models.
When the unobservable common factors are uncorrelated with the explanatory variables, the coefficient estimators from
standard panel estimators are still consistent (but inefficient). However, standard error estimators of commonly applied covari-
ance matrix estimation techniques are biased and statistical inference based on such standard errors is invalid. We estimate
our panel models with Driscoll and Kraay’s 1998 robust standard errors, a non-parametric covariance matrix estimator that
produces heteroskedasticity- and autocorrelation-consistent standard errors that are robust to general forms of spatial and temporal
dependence.

4. Empirical results

4.1. Descriptive analysis and statistics

We provide basic descriptive statistics for our sample in Table 4.1. The panel is balanced and covers 16 cross-section units over
290 monthly observations, for a total of 4,640 observations. However, we note that larger holding period return windows reduce the
number of observations available to each estimation. The mean monthly returns for the pooled data is 0.62% but varies widely from
0.17% in Greece and 1% in Denmark. The returns data is negatively skewed, as reflected in the notable difference between mean
and median monthly returns, and further supported by the difference between the minimum and maximum returns. This skewness
is explained by the few significant losses that characterise market crashes occurring in the period under analysis, particularly the
effects of the European sovereign debt crisis (see, e.g. Lane (2012) for a characterisation of the period). The mean value of the
herding variables is close to zero but not exactly zero because they are extracted as 𝐻𝐸𝑅𝐷𝑚𝑡 = 𝑒𝐻𝑚𝑡 , where 𝐻𝑚𝑡 are the zero-mean
AR(1) variables obtained from the state–space models described in Eqs. (3.7) and (3.8). These variables also show a significant
negative skewness, as adverse herding appears more extreme than intense herding.

7 In 2006, the OMX AB exchange integrated the individual lists of shares traded at the Denmark, Sweden and Finland exchanges into a combined Nordic

List, which was renamed to Nasdaq Nordic in 2008.

8 We applied similar tests to varying holding periods and the results were similar. We omit the results to save space, but they are available upon request.

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

Table 4.1
Descriptive statistics.
Country Obs Market returns Herding variable
Mean Median S.D. Min Max Mean Median S.D. Min Max
Austria 290 0.5545 1.0420 6.5320 −34.2200 24.0800 −0.0283 −0.0195 0.2431 −0.7714 0.4489
Belgium 290 0.5348 1.1470 5.7530 −28.3500 22.3200 −0.0145 0.0343 0.2693 −0.7596 0.4676
Switzerland 290 0.6576 1.0540 4.7590 −17.1900 16.4400 −0.0362 −0.0108 0.2809 −1.0650 0.5079
Germany 290 0.5736 0.9449 6.0090 −20.3900 18.9400 −0.0282 0.0123 0.2559 −1.4460 0.3947
Denmark 290 1.0060 1.4230 5.3130 −24.6800 16.9200 −0.0432 −0.0362 0.2691 −1.0470 0.4086
Spain 290 0.5572 1.0420 6.6020 −22.9000 26.5600 0.0126 0.0319 0.2240 −0.6242 0.5189
Finland 290 0.9830 1.0430 7.7910 −26.8100 30.6500 −0.0398 −0.0015 0.2416 −0.7728 0.4389
France 290 0.6823 0.9898 5.7500 −21.1100 21.3900 −0.0046 0.0548 0.2380 −0.6658 0.4180
UK 290 0.4063 0.7547 4.8240 −20.5800 16.1100 −0.0712 −0.0388 0.2913 −1.0990 0.3623
Greece 290 0.1746 0.5879 10.3300 −33.4500 30.5000 −0.0098 0.0279 0.2326 −0.8035 0.3785
Ireland 290 0.4547 1.3600 6.4660 −29.7900 17.6900 −0.0486 −0.0217 0.3136 −1.3200 0.5357
Italy 290 0.5453 0.8127 6.7590 −22.6500 24.4300 −0.0290 −0.0056 0.2192 −0.9507 0.4925
Netherlands 290 0.6687 1.2270 6.1270 −28.9500 17.1000 −0.0464 −0.0372 0.2673 −0.8451 0.3686
Norway 290 0.7849 1.0270 7.4010 −30.2300 24.4500 −0.0315 −0.0295 0.2473 −0.7482 0.5029
Portugal 290 0.4137 0.5819 6.1610 −28.3800 17.5300 0.0131 0.0463 0.2611 −0.9423 0.5636
Sweden 290 0.8929 0.9810 6.9370 −26.0200 22.0400 −0.0395 −0.0518 0.2524 −0.8687 0.4015
Pooled 4,640 0.6182 0.9791 6.5880 −34.2158 30.6536 −0.0278 0.0011 0.2583 −1.4465 0.5636

Notes: This table shows descriptive statistics for the countries in the analysis. We report mean, median, standard deviation, minimum and maximum statistics
for excess market returns and the herding variables (Eq. (3.9)). Our panel covers 16 cross-section units over 290 monthly observations from November 1996 to
December 2020.

4.2. Market returns conditional on herding states

We start our analysis by investigating the market performance, measured by raw returns, conditional on herding states. In Panel
A of Table 4.2, we report the estimates of 𝜙1 and 𝜙2 corresponding to the change in mean raw monthly returns associated with
INT and ADV herding states relative to the neutral state (not reported in the table). To save space, we omit the results for some in
between holding periods. Between November 1996 and December 2020, the mean raw returns following INT herding states (upper
quintile) are significantly lower at the 5% level than following neutral states (middle quintiles) for holding periods between three and
nine months. For these holding windows, the estimates for the coefficients 𝜙1 associated with the INT herding state range between
−0.23% (t-statistic: −2.29) and −0.30% (t-statistic: −2.39), reaching a peak in the three-month holding period and then decreasing
gradually over time. These results are also significant in economic terms. Conditional on an INT herding state, mean returns are
0.30% lower than after a neutral state over the following three months. Although the effect declines over time, the impact over one
year accumulates to −2.44% (−0.2035 × 12 months). The ADV herding state does not change market returns significantly over any
of the holding periods considered, as the estimates for 𝜙2 are not statistically significant.
We highlight the gradually decreasing impact of the INT herding state on market returns, a finding with both statistical and
economic implications. First, Valkanov (2003) suggests that predictability at long horizons, when there is none at short horizons,
may result from not correctly adjusting standard errors. It is not the case with our results, as the estimates for the 𝜙1 coefficients
lose statistical significance at longer horizons. Second, a gradually increasing and statistically significant parameter without any
reversion seems unreasonable from a theoretical viewpoint, as it would mean that markets gradually move away from equilibrium
values. Even if persistent, herd behaviour is a mean reverting process; hence it is not expected to lead towards a permanent bias.
In Panel B, we report the t-statistics for testing the equality of the mean returns across INT and ADV herding states for the holding
periods considered in Panel A. We provide p-values for the two-tailed Wald test on the equality of coefficients and the lower-tailed
Wald test on the alternative hypothesis 𝐻𝑎 ∶ 𝜙1 − 𝜙2 < 0. As the estimates for 𝜙1 − 𝜙2 are negative for all holding periods, we do not
conduct an upper-tailed test. The results from Wald tests reject the null hypothesis that the raw returns for INT herding and ADV
herding are equal for a holding period of up to 18 months, with a statistical significance of 10%. The lower-tailed tests support the
evidence of raw returns for INT herding states being lower than for ADV herding states, with a statistical significance of 5% for the
same windows. We plot the estimated impact of herding states on subsequent raw returns for forecast horizons between one and
48 months in Panel A of Fig. 4.1. There is a clear difference in performance between the two states, which gradually decreases over
time.
To give robustness to our findings, we also provide estimation results for benchmark-adjusted mean monthly market returns
conditional on herding states, using the CAPM and the FF5F+ model in Panels A of Tables 4.3 and 4.4. Looking at the CAPM-adjusted
results first, the mean monthly returns following INT herding states are significantly lower than following neutral states across all
holding periods up to 39 months. The negative impact in mean returns of an INT state peaks at 0.38% (t-statistic: −3.04) for a
one-month holding period and decreases gradually over time. Conditional on an INT herding state, mean CAPM-adjusted returns
are, on average, 2.71% (−0.2258 × 12 months) lower than after a neutral herding state over the following year. Similarly to the case
for raw returns, we do not find evidence of an ADV state having a significant impact on future returns. In Panel B of Table 4.3, we
report the results for equality tests similar to those in Table 4.2. The null hypothesis 𝐻0 ∶ 𝜙1 −𝜙2 = 0 is rejected at the 5% significant
level for holding periods up to 30 months. The lower-tailed tests support the evidence that CAPM-adjusted returns following an INT

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Table 4.2
Raw mean monthly market returns conditional on herding states.
Holding period Panel A: Holding period mean monthly returns Panel B: Wald tests for equality
Months 𝐼𝑁𝑇 𝐴𝐷𝑉 𝑁 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡 𝜙̂ 1 − 𝜙̂ 2 𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝐻𝑎 ∶ 𝜙1 − 𝜙2 < 0
1 −0.2810 0.0256 4,624 0.7096 39.96*** −0.3066
(−1.5683) (0.1548) −1.3340 0.1823 0.0911*
3 −0.3047** 0.0239 4,592 0.7280 43.66*** −0.3287
(−2.3924) (0.2045) −1.9341 0.0532* 0.0266**
6 −0.2617** 0.0017 4,544 0.7364 45.54*** −0.2634
(−2.3507) (0.0175) −1.8424 0.0655* 0.0327**
9 −0.2344** 0.0033 4,496 0.7270 43.44*** −0.2377
(−2.2888) (0.0389) −1.6851 0.0920* 0.0460**
12 −0.2035* 0.0379 4,448 0.7073 39.52*** −0.2413
(−1.9459) (0.4514) −1.7068 0.0879* 0.0440**
15 −0.2176** 0.0544 4,400 0.6937 37.09*** −0.2720
(−2.0636) (0.6022) −1.9109 0.0561* 0.0280**
18 −0.2124* 0.0433 4,352 0.6857 35.77*** −0.2557
(−1.9249) (0.4787) −1.7520 0.0799* 0.0399**
21 −0.1880 0.0398 4,304 0.6817 35.13*** −0.2278
(−1.6403) (0.4750) −1.5245 0.1275 0.0637*
24 −0.1812 0.0186 4,256 0.6777 34.51*** −0.1999
(−1.6080) (0.2594) −1.4136 0.1576 0.0788*
27 −0.1734 0.0051 4,208 0.6677 33.02*** −0.1785
(−1.6200) (0.0718) −1.3510 0.1768 0.0884*
30 −0.1506 0.0161 4,160 0.6546 31.20*** −0.1666
(−1.3811) (0.2417) −1.2581 0.2084 0.1042
33 −0.1328 0.0209 4,112 0.6403 29.37*** −0.1537
(−1.2630) (0.3335) −1.2266 0.2201 0.1100
36 −0.1157 0.0327 4,064 0.6294 28.06*** −0.1485
(−1.1619) (0.5392) −1.2199 0.2226 0.1113
39 −0.0884 0.0391 4,016 0.6203 27.03*** −0.1275
(−0.9022) (0.6774) −1.0808 0.2799 0.1399
42 −0.0622 0.0403 3,968 0.6162 26.58*** −0.1025
(−0.6421) (0.7456) −0.8930 0.3719 0.1860
45 −0.0485 0.0407 3,920 0.6141 26.35*** −0.0892
(−0.4835) (0.8506) −0.8005 0.4234 0.2117
48 −0.0583 0.0263 3,872 0.6096 25.87*** −0.0846
(−0.5663) (0.5863) −0.7582 0.4484 0.2242

Notes: In Panel A, we report the estimation results for Model 1 described in Eq. (3.12), using raw returns as the independent variable between November 1996
and December 2020. The panel regressions are estimated with cross-sectional and time fixed effects, with Driscoll and Kraay’s (1998) robust standard errors,
where the number of lags is set equal to 𝑛 − 1, corresponding to the number of overlapping months in the holding period window. The numbers in parentheses
are the 𝑡-statistics. In Panel B, we report the results of two-tailed tests on the null hypothesis 𝐻0 ∶ 𝜙1 = 𝜙2 , and lower-tailed tests on the alternative hypothesis
𝐻𝑎 ∶ 𝜙1 < 𝜙2 . Since 𝜙̂ 1 − 𝜙̂ 2 is negative for all holding periods, we do not conduct upper-tailed tests. In the first column, we report coefficient estimates and
𝑡-statistics. The values reported for the Wald tests are p-values. In both panels, ***, ** and * denote statistical significance at the 1%, 5% and 10% levels,
respectively.

herding state are lower than following an ADV herding state for almost all estimation windows and at the 1% level for holding
periods between up to 18 months.
Advancing to the FF5F-adjusted returns, we verify a pattern confirming the evidence already presented, even though the overall
significance is reduced. The mean monthly returns following INT herding states are significantly lower than following neutral
states up to a nine-month holding period. Conditional on an INT herding state, mean FF5F-adjusted returns are, on average, 1.57%
(−0.1311 × 12 months) lower than after a neutral herding state over the following year. The two-tailed and lower-tailed Wald tests
provided in Panel B of Table 4.4 reject the null hypothesis of 𝐻0 ∶ 𝜙1 − 𝜙2 = 0 at the 5% significance level for holding periods
up to six months and support the alternative hypothesis that risk-adjusted returns following an INT herding state are lower than
following an ADV herding state.
We plot the results for the benchmark-adjusted returns in Panel B (CAPM-adjusted) and Panel C (FF5F-adjusted) of Fig. 4.1.
The observed lower returns following an INT herding state across raw and benchmark-adjusted models are consistent with price
correction and overpricing and align with the behavioural theory of overreaction and underreaction (Barberis et al., 1998; Daniel
et al., 1998). Beta herding is modelled as a mean-reverting AR(1) process; hence we expect extreme states to revert and the effects
on returns deriving from beta biases to dissipate over time (Hwang and Salmon, 2004; Hwang et al., 2021).

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

Fig. 4.1. Cumulative monthly returns conditioning on herding states.

Notes: This figure shows the cumulative monthly raw (Panel A), CAPM-adjusted (Panel B) and FF5F-adjusted (Panel C) returns conditioning on the herding state
being INT or ADV.

4.3. The role of past market returns

We expand our analysis to investigate under which market conditions beta herding arises. We adapt Model 1, presented in
Eq. (3.12), to evaluate the performance of the market return series, 𝑅𝑛,𝑖𝑡 in the period before the identification of the herding state:
(Model 2)

𝑅𝑛,𝑖𝑡 = 𝜙1 𝐷𝑡𝐼𝑁𝑇 + 𝜙2 𝐷𝑡𝐴𝐷𝑉 + 𝛿𝑖 + 𝜃𝑡 + 𝜖𝑖𝑡 , (4.1)

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Table 4.3
CAPM-adjusted mean monthly market returns conditional on herding states.
Holding period Panel A: Holding period mean monthly returns Panel B: Wald tests for equality
Months 𝐼𝑁𝑇 𝐴𝐷𝑉 𝑁 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡 𝜙̂ 1 − 𝜙̂ 2 𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝐻𝑎 ∶ 𝜙1 − 𝜙2 < 0
1 −0.3755*** −0.0354 4,624 0.0015 4.45** −0.3401
(−3.0436) (−0.3137) −2.4787 0.0132** 0.0066***
3 −0.3585*** −0.0206 4,592 0.0044 11.23*** −0.3379
(−4.4179) (−0.2525) −2.9446 0.0032*** 0.0016***
6 −0.2896*** −0.0080 4,544 0.0054 13.28*** −0.2816
(−3.9711) (−0.0988) −2.6090 0.0091*** 0.0046***
9 −0.2609*** −0.0011 4,496 0.0061 14.75*** −0.2598
(−3.6092) (−0.0152) −2.3955 0.0166** 0.0083***
12 −0.2258*** 0.0231 4,448 0.0060 14.48*** −0.2490
(−2.8991) (0.3476) −2.3215 0.0203** 0.0102**
15 −0.2152*** 0.0374 4,400 0.0069 16.37*** −0.2526
(−2.6923) (0.5903) −2.4054 0.0162** 0.0081***
18 −0.2114** 0.0343 4,352 0.0077 17.99*** −0.2457
(−2.5879) (0.5713) −2.3656 0.0180** 0.0090***
21 −0.1879** 0.0413 4,304 0.0073 16.74*** −0.2292
(−2.2699) (0.7554) −2.2080 0.0273** 0.0136**
24 −0.1818** 0.0282 4,256 0.0071 16.11*** −0.2100
(−2.2650) (0.5687) −2.1238 0.0337** 0.0169**
27 −0.1867** 0.0093 4,208 0.0078 17.51*** −0.1960
(−2.5662) (0.1891) −2.2169 0.0267** 0.0133**
30 −0.1683** 0.0088 4,160 0.0069 15.55*** −0.1771
(−2.2734) (0.2001) −2.0207 0.0434** 0.0217**
33 −0.1519** 0.0047 4,112 0.0061 13.70*** −0.1565
(−2.0271) (0.1141) −1.8112 0.0702* 0.0351**
36 −0.1487** 0.0024 4,064 0.0064 14.13*** −0.1511
(−2.0130) (0.0624) −1.7641 0.0778* 0.0389**
39 −0.1351* 0.0015 4,016 0.0058 12.64*** −0.1365
(−1.7594) (0.0410) −1.6016 0.1093 0.0547*
42 −0.1205 0.0025 3,968 0.0050 10.99*** −0.1230
(−1.5263) (0.0717) −1.4369 0.1508 0.0754*
45 −0.1088 0.0002 3,920 0.0043 9.50*** −0.1090
(−1.2968) (0.0059) −1.2216 0.2219 0.1110
48 −0.1117 −0.0091 3,872 0.0046 9.96*** −0.1026
(−1.3282) (−0.2888) −1.1361 0.2560 0.1280

Notes: In Panel A, we report the estimation results for Model 1 described in Eq. (3.12), using CAPM-adjusted returns as the independent variable between
November 1996 and December 2020. The panel regressions are estimated with cross-sectional fixed effects, with Driscoll and Kraay’s (1998) robust standard
errors, where the number of lags is set equal to 𝑛 − 1, corresponding to the number of overlapping months in the holding period window. The numbers in
parentheses are the 𝑡-statistics. In Panel B, we report the results of two-tailed tests on the null hypothesis 𝐻0 ∶ 𝜙1 = 𝜙2 and lower-tailed tests on the alternative
hypothesis 𝐻𝑎 ∶ 𝜙1 < 𝜙2 . Since 𝜙̂ 1 − 𝜙̂ 2 is negative for all holding periods, we do not conduct upper-tailed tests. In the first column, we report coefficient estimates
and 𝑡-statistics. The values reported for the Wald tests are p-values. In both panels, ***, ** and * denote statistical significance at the 1%, 5% and 10% levels,
respectively.

where 𝑡 = 𝑛, … , 290 and 𝑛 = 1, … , 12, while all other notation remains unchanged from our presentation of Model 1. We report
in Table 4.5 the raw, CAPM-adjusted and FF5F-adjusted mean monthly returns for periods up to 12 months before the advent of
herding states. Again, we omit the reporting of results for some in-between holding periods.
One empirical regularity observed over the table is that market returns are lower (higher) before an INT (ADV) state relative
to the neutral state. The difference between the INT and ADV gradually increases in absolute terms. The estimated parameters 𝜙1
and 𝜙2 are not statistically significant across the raw and CAPM-adjusted returns models. However, we find the coefficients for both
states statistically significant for the FF5F-adjusted returns in several windows. Moreover, the Wald tests for equality reject the null
hypothesis 𝐻0 ∶ 𝜙 − 𝜙2 = 0 and support the alternative hypothesis of the return associated with the INT herding state being lower
than the return associated with the ADV herding state. Intense (adverse) beta herding arises during periods of lower (higher) market
returns.

4.4. The role of market volatility

To confirm whether market volatility plays a role in defining herding states, we compute the mean volatility,
√
√ 𝑛 ( )
√1 ∑
𝜎𝑗,𝑛,𝑡 = √ 𝜎2 , (4.2)
𝑛 𝑡=1 𝑗𝑡

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

Table 4.4
FF5F-adjusted mean monthly market returns conditional on herding states.
Holding period Panel A: Holding period mean monthly returns Panel B: Wald tests for equality
Months 𝐼𝑁𝑇 𝐴𝐷𝑉 𝑁 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡 𝜙̂ 1 − 𝜙̂ 2 𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝐻𝑎 ∶ 𝜙1 − 𝜙2 < 0
1 −0.1487 0.1273 4,624 0.0005 2.10 −0.2759
(−1.3088) (1.1838) −2.0800 0.0376** 0.0188**
3 −0.1609* 0.1615 4,592 0.0028 7.41*** −0.3225
(−1.8045) (1.6491) −2.5026 0.0124** 0.0062***
6 −0.1531* 0.0744 4,544 0.0025 6.79*** −0.2275
(−1.8172) (0.8866) −1.9637 0.0496** 0.0248**
9 −0.1473* 0.0260 4,496 0.0023 6.09*** −0.1733
(−1.7697) (0.3521) −1.6466 0.0997* 0.0499**
12 −0.1311 0.0307 4,448 0.0023 6.17*** −0.1618
(−1.4983) (0.4922) −1.5687 0.1168 0.0584*
15 −0.1154 0.0526 4,400 0.0028 7.08*** −0.1680
(−1.2944) (0.9062) −1.6808 0.0929* 0.0464**
18 −0.1201 0.0475 4,352 0.0033 8.29*** −0.1676
(−1.3435) (0.8209) −1.7091 0.0875* 0.0437**
21 −0.1154 0.0404 4,304 0.0034 8.28*** −0.1557
(−1.2673) (0.7006) −1.5620 0.1184 0.0592*
24 −0.1105 0.0318 4,256 0.0032 7.91*** −0.1423
(−1.2298) (0.5168) −1.4041 0.1604 0.0802*
27 −0.1167 0.0168 4,208 0.0036 8.50*** −0.1336
(−1.3338) (0.2600) −1.3366 0.1814 0.0907*
30 −0.1145 0.0162 4,160 0.0036 8.61*** −0.1307
(−1.3260) (0.2398) −1.3095 0.1905 0.0952*
33 −0.0989 0.0210 4,112 0.0031 7.47*** −0.1199
(−1.1705) (0.2986) −1.1950 0.2322 0.1161
36 −0.0949 0.0323 4,064 0.0034 8.01*** −0.1272
(−1.1832) (0.4528) −1.2699 0.2042 0.1021
39 −0.0882 0.0347 4,016 0.0034 7.75*** −0.1230
(−1.1479) (0.4989) −1.2346 0.2171 0.1085
42 −0.0765 0.0375 3,968 0.0031 7.14*** −0.1140
(−0.9760) (0.5577) −1.1440 0.2527 0.1264
45 −0.0682 0.0316 3,920 0.0028 6.43*** −0.0998
(−0.8639) (0.5425) −1.0385 0.2991 0.1496
48 −0.0672 0.0170 3,872 0.0025 5.82*** −0.0842
(−0.8893) (0.3300) −0.9302 0.3523 0.1762

Notes: In Panel A, we report the estimation results for Model 1 described in Eq. (3.12), using FF5F-adjusted returns as the independent variable
between November 1996 and December 2020. The panel regressions are estimated with cross-sectional fixed effects, with Driscoll and Kraay’s
(1998) robust standard errors, where the number of lags is set equal to 𝑛 − 1, corresponding to the number of overlapping months in the holding
period window. The numbers in parentheses are the 𝑡-statistics. In Panel B, we report the results of two-tailed tests on the null hypothesis
𝐻0 ∶ 𝜙1 = 𝜙2 and lower-tailed tests on the alternative hypothesis 𝐻𝑎 ∶ 𝜙1 < 𝜙2 . Since 𝜙̂ 1 − 𝜙̂ 2 is negative for all holding periods, we do not
conduct upper-tailed tests. In the first column, we report coefficient estimates and 𝑡-statistics. The values reported for the Wald tests are p-values.
In both panels, ***, ** and * denote statistical significance at the 1%, 5% and 10% levels, respectively.

where 𝜎 2 𝑗𝑡 is the realised variance of excess market returns in month 𝑡 for country 𝑗, with 𝑛 = 1, … , 12. We obtain the variance of
excess market returns for each country from one-month intervals of daily returns as in Schwert (1989). To investigate the impact of
volatility, we re-estimate Model 1 and Model 2, replacing 𝑅𝑛,𝑖𝑡 for 𝜎𝑗,𝑛,𝑡 . This method allows controlling for fixed effects. We report
the results in Table 4.6.
We observe that the coefficients relative to the ADV state are almost all statistically significant, with all estimates being negative.
The mean market volatility before and after ADV herding states is significantly lower than following neutral states for almost all
the holding periods reported. One month before the advent of an ADV state, the standard deviation is −0.31% (t-statistic: −5.00)
lower than before a neutral state, on average. These results are also significant in economic terms, as the pooled standard deviation
for our dataset is 6.59%. The Wald tests reported in Panel B confirm the alternative hypothesis 𝐻0 ∶ 𝜙1 − 𝜙2 > 0 for holding periods
between nine months before and 12 months after the herding state. Therefore, we observe that market volatility is significantly
lower during periods of adverse herding than during periods of intense herding.
Herd behaviour appears to be more pronounced during declining markets and rising volatility. These results contradict the
evidence presented by Hwang et al. (2021), as they find that adverse beta herding prevails during turbulent periods of low returns
and high volatility. However, our results align with the behavioural theory attributing the presence of common biases to intuitive
judgements under uncertainty (Tversky and Kahneman, 1974) and corroborate the findings of Chiang and Zheng (2010), Demirer

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

Table 4.5
Mean monthly market returns before herding states.
Holding period Panel A: Holding period mean monthly returns Panel B: Wald tests for equality
Months 𝐼𝑁𝑇 𝐴𝐷𝑉 𝑁 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡 𝜙̂ 1 − 𝜙̂ 2 𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝐻𝑎 ∶ 𝜙1 − 𝜙2 < 0 𝐻𝑎 ∶ 𝜙1 − 𝜙2 > 0
Raw returns

−12 0.0317 0.0831 4,464 0.7065 39.36*** −0.0514

(0.2797) (0.6469) −0.4340 0.6643 0.3322
−9 −0.0121 0.1143 4,512 0.7265 43.35*** −0.1264
(−0.0920) (0.8573) −0.8995 0.3684 0.1842
−6 −0.0022 0.1602 4,560 0.7357 45.36*** −0.1623
(−0.0160) (1.1449) −0.9336 0.3506 0.1753
−3 −0.0456 0.1028 4,608 0.7270 43.44*** −0.1484
(−0.3210) (0.6583) −0.7093 0.4782 0.2391
−1 −0.0713 0.1142 4,640 0.7091 39.87*** −0.1855
(−0.3712) (0.6358) −0.7357 0.4620 0.2310
CAPM-adjusted returns

−12 −0.1516 −0.0289 4,464 0.0022 5.90*** −0.1227

(−1.5128) (−0.2935) −1.0281 0.3039 0.1520
−9 −0.1656 0.0096 4,512 0.0023 6.31*** −0.1751
(−1.5514) (0.0973) −1.5205 0.1285 0.0642*
−6 −0.1593 0.0803 4,560 0.0023 6.27*** −0.2396
(−1.5330) (0.8375) −2.1336 0.0329** 0.0165**
−3 −0.2028** 0.0481 4,608 0.0015 4.39** −0.2509
(−2.0034) (0.4930) −2.0186 0.0436** 0.0218**
−1 −0.2004 0.0600 4,640 0.0003 1.64 −0.2603
(−1.5714) (0.4716) −1.7475 0.0806* 0.0403**
FF5F-adjusted returns
−12 −0.1497** 0.1236 4,464 0.0053 12.98*** −0.2733
(−2.2945) (1.4124) −2.4350 0.0149** 0.0075***
−9 −0.1445** 0.1689** 4,512 0.0060 14.57*** −0.3134
(−2.0584) (2.0740) −2.9892 0.0028*** 0.0014***
−6 −0.1318* 0.1751** 4,560 0.0044 11.08*** −0.3070
(−1.8144) (1.9880) −2.8455 0.0045*** 0.0022***
−3 −0.1270 0.1387 4,608 0.0017 5.03*** −0.2657
(−1.5265) (1.4334) −2.2048 0.0275** 0.0138**
−1 −0.0801 0.1867* 4,640 0.0005 2.14 −0.2668
(−0.6945) (1.8560) −2.0187 0.0436** 0.0218**

Notes: In Panel A, we report the estimation results for Model 2 described in Eq. (4.1), using raw, CAPM-adjusted and FF5F-adjusted returns as the independent
variable between November 1996 and December 2020. The panel regressions are estimated with cross-sectional and time fixed effects for raw returns and
cross-sectional fixed effects for CAPM-adjusted and FF5F-returns, with Driscoll and Kraay’s (1998) robust standard errors, where the number of lags is set equal
to 𝑛 − 1, corresponding to the number of overlapping months in the holding period window. The numbers in parentheses are the 𝑡-statistics. In Panel B, we
report the results of two-tailed tests on the null hypothesis 𝐻0 ∶ 𝜙1 = 𝜙2 , and the relevant one-tailed tests on either the alternative hypothesis 𝐻𝑎 ∶ 𝜙1 < 𝜙2 or
𝐻𝑎 ∶ 𝜙1 > 𝜙2 . In the first column, we report coefficient estimates and 𝑡-statistics. The values reported for the Wald tests are p-values. In both panels, ***, **
and * denote statistical significance at the 1%, 5% and 10% levels, respectively.

et al. (2010), Litimi et al. (2016), who find herding to increase with volatility and uncertainty. Our results are also supported
by Venezia et al.’s 2011 argument that herding is information-based in the sense that a lack of information drives it.

4.5. Herding as a continuous variable

To give robustness to our previous findings, we expand the analysis to examine the relationship between the lagged herding and
market returns using herding as a continuous variable, as an alternative to the dichotomous variables identifying extreme herding
states in the previous sections. We regress market returns on lagged herding and the square of lagged herding to investigate whether
market returns decrease monotonically with lagged herding. A statistically significant coefficient for the squared variable suggests
a non-linear relationship between herding and market returns. We estimate the following model,
(Model 3)
2
𝑅𝑛,𝑖𝑡 = 𝜙1 𝐻𝑒𝑟𝑑𝑚𝑡−𝑛 + 𝜙2 𝐻𝑒𝑟𝑑𝑚𝑡−𝑛 + 𝛿𝑖 + 𝜃𝑡 + 𝜖𝑖𝑡 , (4.3)
where 𝐻𝑒𝑟𝑑𝑚𝑡−𝑛 and 𝐻𝑒𝑟𝑑𝑚𝑡−𝑛 2 are the continuous herding variable, and its squared value lagged by 𝑛 periods, respectively. In Model
3, 𝑡 = 1 + 𝑛, … , 290 and 𝑛 = 1, … , 48, while all other notation remains unchanged from our presentation of Model 1.
We report the results in Table 4.7. As shown across the panels, the raw and benchmark-adjusted returns are negatively related
to lagged herding, confirming our findings that market return is high (low) when lagged herding is low (high). Panel A indicates

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

Table 4.6
Mean monthly standard deviation of market returns and herding states.
Holding period Panel A: Holding period mean monthly standard deviation Panel B: Wald tests for equality
Months 𝐼𝑁𝑇 𝐴𝐷𝑉 𝑁 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡 𝜙̂ 1 − 𝜙̂ 2 𝐻0 ∶ 𝜙1 − 𝜙2 = 0 𝐻𝑎 ∶ 𝜙1 − 𝜙2 > 0
Mean monthly standard deviation of market returns before herding states
−12 0.0110 −0.1823 4,464 0.6396 29.28*** 0.1933
(0.0666) (−1.5571) 1.1106 0.2668 0.1334
−9 0.0624 −0.2244** 4,512 0.6589 31.80*** 0.2868
(0.3514) (−2.0209) 1.5527 0.1206 0.0603*
−6 0.1213 −0.2533** 4,560 0.6781 34.58*** 0.3746
(0.6745) (−2.4456) 1.9703 0.0489** 0.0244**
−3 0.1509 −0.2878*** 4,608 0.6979 37.82*** 0.4387
(0.9269) (−3.3163) 2.5999 0.0094*** 0.0047***
−1 0.1398 −0.3089*** 4,640 0.6990 38.02*** 0.4487
(1.3297) (−5.0031) 3.9713 0.0001*** 0.0000***
Mean monthly standard deviation of market returns after herding states
1 0.2054* −0.3507*** 4,624 0.6989 38.01*** 0.5561
(1.9117) (−5.4284) 4.8568 0.0000*** 0.0000***
3 0.2385 −0.3338*** 4,592 0.6983 37.90*** 0.5723
(1.4375) (−3.8617) 3.3350 0.0009*** 0.0004***
6 0.2447 −0.3422*** 4,544 0.6796 34.80*** 0.5869
(1.2621) (−3.4748) 2.8126 0.0049*** 0.0025***
9 0.2433 −0.3488*** 4,496 0.6611 32.09*** 0.5921
(1.1575) (−3.3743) 2.6195 0.0088*** 0.0044***
12 0.2247 −0.3715*** 4,448 0.6428 29.69*** 0.5962
(1.0395) (−3.3921) 2.5887 0.0097*** 0.0048***

Notes: In Panel A, we report the estimation results for the mean standard deviation of monthly excess returns using a variant of Models 1 and 2 as described in
the text between November 1996 and December 2020. The panel regressions are estimated with cross-sectional and time fixed effects, with Driscoll and Kraay’s
(1998) robust standard errors, where the number of lags is set equal to 𝑛 − 1, corresponding to the number of overlapping months in the holding period window.
The numbers in parentheses are the 𝑡-statistics. In Panel B, we report the results of two-tailed tests on the null hypothesis 𝐻0 ∶ 𝜙1 = 𝜙2 , and upper-tailed tests
on the alternative hypothesis 𝐻𝑎 ∶ 𝜙1 > 𝜙2 . Since 𝜙̂ 1 − 𝜙̂ 2 is positive for all holding periods, we do not conduct lower-tailed tests. In the first column, we report
coefficient estimates and 𝑡-statistics. The values reported for the Wald tests are p-values. In both panels, ***, ** and * denote statistical significance at the 1%,
5% and 10% levels, respectively.

a negative relationship between lagged herding and raw mean market returns for holding periods between three and nine months,
with the estimated impact from one-unit change in the herding level being between −0.47% and −0.53% in mean market returns
per month. However, the results are only significant at the 10% level. The CAPM-adjusted and FF5F-adjusted returns reported in
Panels B and C, respectively, confirm the negative estimate for the herding variable. The herding variable is negative and statistically
significant at the 5% level for holding periods up to 21 months in the CAPM model and up to six months in the FF5F model. A
one-unit increase in the herding variable reduces raw returns by 2.89% (−0.4823 × 6 months), CAPM-returns by 2.48% (−0.4136 × 6
months) and FF5F-adjusted returns by 1.91% (−0.3181×12 months) over the following six months. Interestingly, the squared herding
variables are not statistically significant, and are not capturing non-linearity.9

5. Conclusions

Motivated by a gap in the literature, we investigate whether conditioning on the state of beta herding has predictive power for
stock market returns, by regressing aggregate-level market returns on lagged herding states. We estimate herding time series for 16
European countries and use the quintiles of the distributions to identify three herding states: intense herding (INT) corresponding
to the upper quintile, adverse herding (ADV) corresponding to the lower quintile, and neutral herding to capture the middle of the
distributions. Our main contribution is to show that stock market returns are markedly dependent on past herding states.
The results from the estimations indicate that excess market returns are significantly lower following periods of intense herding
behaviour than adverse herding, suggesting overpricing. The mean excess market returns following an INT state are, on average,
0.33% lower per month over a three-month holding period than following an ADV herding state. The return spread between INT
and ADV states dissipates over time, but it is statistically significant for holding periods of up to 18 months. These results are fuelled
by a statistically significant negative return following an INT herding state, as we find no evidence of significant returns following
an ADV state.
Conditional on an INT herding state, the accumulated excess market returns after one year are, on average, 2.44% (−0.2035 × 12
months) lower than following a neutral state. Tests on equality of the impact on subsequent returns conditional on INT versus

9 These results do not necessarily exclude non-linearity between herding and market returns, as higher-order herding terms and other non-linear forms of

herding, not considered in this paper, could be statistically significant. However, such investigation is beyond the scope of our research.

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

Table 4.7
Mean monthly market returns and lagged continuous herding.
Hold. per. Panel A: Raw returns Panel B: CAPM-adjusted returns Panel C: FF5F-adjusted returns

Months 𝑁 𝐻𝑒𝑟𝑑 𝐻𝑒𝑟𝑑_𝑠𝑞𝑟 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡 𝐻𝑒𝑟𝑑 𝐻𝑒𝑟𝑑_𝑠𝑞𝑟 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡 𝐻𝑒𝑟𝑑 𝐻𝑒𝑟𝑑_𝑠𝑞𝑟 𝑅2 − 𝑎𝑑𝑗 𝐹 − 𝑠𝑡𝑎𝑡

1 4,624 −0.4577 0.3930 0.7098 39.99*** −0.4336** 0.2501 4,624 0.0012 3.73** −0.4017** 0.3286 4,624 0.0018
(−1.2625) (0.5979) (−2.2460) (0.4610) (−2.1757) (0.6846)

3 4,592 −0.5256* −0.2784 0.7280 43.66*** −0.4577*** −0.2973 4,592 0.0027 7.12*** −0.3937** 0.1145 4,592 0.0041
(−1.6842) (−0.5873) (−2.6691) (−0.8123) (−2.2959) (0.3043)

6 4,544 −0.4823* −0.5587 0.7366 45.57*** −0.4136** −0.3901 4,544 0.0041 10.25*** −0.3181** −0.0503 4,544 0.0040
(−1.7663) (−1.3148) (−2.5225) (−1.1586) (−2.1579) (−0.1635)

9 4,496 −0.4679* −0.4818 0.7273 43.52*** −0.3924** −0.3338 4,496 0.0053 12.88*** −0.2712* −0.1059 4,496 0.0038
(−1.7470) (−1.2393) (−2.2972) (−1.0955) (−1.9677) (−0.3928)

12 4,448 −0.4222 −0.4797 0.7078 39.60*** −0.3439** −0.3240 4,448 0.0050 12.28*** −0.2138 −0.0585 4,448 0.0033
(−1.5390) (−1.2015) (−2.0068) (−1.1090) (−1.4998) (−0.2313)

15 4,400 −0.4696 −0.4776 0.6943 37.19*** −0.3512** −0.2994 4,400 0.0064 15.06*** −0.2194 −0.0071 4,400 0.0045
(−1.6399) (−1.1110) (−2.0907) (−1.0054) (−1.4868) (−0.0276)

18 4,352 −0.4751* −0.5370 0.6867 35.93*** −0.3546** −0.3468 4,352 0.0075 17.37*** −0.2074 −0.0102 4,352 0.0049
(−1.6664) (−1.2606) (−2.1965) (−1.2224) (−1.3688) (−0.0357)

21 4,304 −0.4058 −0.4477 0.6825 35.25*** −0.3185** −0.2699 4,304 0.0070 16.17*** −0.1983 −0.0141 4,304 0.0052
(−1.4229) (−1.0662) (−2.0030) (−0.9583) (−1.3144) (−0.0460)

24 4,256 −0.3493 −0.3628 0.6782 34.59*** −0.2932* −0.2400 4,256 0.0067 15.25*** −0.1804 −0.0017 4,256 0.0051
(−1.2438) (−0.8830) (−1.9106) (−0.8651) (−1.1971) (−0.0056)

27 4,208 −0.3303 −0.3072 0.6682 33.10*** −0.2821* −0.2308 4,208 0.0068 15.42*** −0.1698 0.0184 4,208 0.0053
(−1.1905) (−0.7637) (−1.8911) (−0.8420) (−1.0991) (0.0584)

30 4,160 −0.3185 −0.2895 0.6555 31.32*** −0.2650* −0.2402 4,160 0.0066 14.75*** −0.1666 −0.0123 4,160 0.0052
(−1.1696) (−0.7503) (−1.7968) (−0.8841) (−1.0703) (−0.0393)

33 4,112 −0.2908 −0.2755 0.6413 29.49*** −0.2421* −0.2601 4,112 0.0060 13.32*** −0.1636 0.0000 4,112 0.0054
(−1.1519) (−0.7704) (−1.6833) (−0.9793) (−1.0463) (0.0002)

36 4,064 −0.2641 −0.2560 0.6304 28.18*** −0.2347* −0.2942 4,064 0.0061 13.53*** −0.1682 0.0114 4,064 0.0060
(−1.1084) (−0.7712) (−1.6688) (−1.1323) (−1.0784) (0.0373)

39 4,016 −0.2309 −0.2064 0.6215 27.16*** −0.2235 −0.2872 4,016 0.0061 13.40*** −0.1671 0.0466 4,016 0.0067
(−1.0144) (−0.6432) (−1.6219) (−1.0887) (−1.0671) (0.1527)

42 3,968 −0.1972 −0.1946 0.6175 26.72*** −0.2075 −0.3019 3,968 0.0059 12.69*** −0.1573 0.0011 3,968 0.0064
(−0.9040) (−0.6177) (−1.5239) (−1.1561) (−1.0288) (0.0042)

45 3,920 −0.1904 −0.2182 0.6156 26.52*** −0.1994 −0.3243 3,920 0.0059 12.71*** −0.1526 −0.0677 3,920 0.0063
(−0.8797) (−0.6687) (−1.4500) (−1.2543) (−1.0443) (−0.2725)

48 3,872 −0.2002 −0.3134 0.6115 26.08*** −0.1990 −0.3822 3,872 0.0065 13.73*** −0.1460 −0.1461 3,872 0.0058
(−0.9503) (−0.9894) (−1.4966) (−1.5759) (−1.0746) (−0.6376)

Notes: We report the estimation results for Model 3 described in Eq. (4.3), using raw (Panel A), CAPM-adjusted (Panel B) or FF5F-adjusted (Panel C) returns as the independent variable between
November 1996 and December 2020. The panel regressions are estimated with cross-sectional and time fixed effects for raw returns and cross-sectional fixed effects for CAPM-adjusted and FF5F-returns,
with Driscoll and Kraay’s (1998) robust standard errors, where the number of lags is set equal to 𝑛 − 1, corresponding to the number of overlapping months in the holding period window. The
numbers in parentheses are the 𝑡-statistics. ***, ** and * denote statistical significance at the 1%, 5% and 10% levels, respectively.

an ADV state are rejected with a statistical significance of 5% for holding periods between three and 18 months, supporting the
alternative hypothesis that market returns are lower following an INT herding state than following an ADV herding state. These
results are further confirmed in regressions using a continuous lagged herding variable. Moreover, the possibility that market returns
decrease linearly with herding cannot be discarded, as the quadratic parameter in our regressions is not statistically significant.
The evidence presented in this study corroborates the findings of Hwang et al. (2021) showing that market returns are markedly
conditional on past herd behaviour. However our results contrast with their findings regarding the market conditions under which
herding is more prevalent, as we find herd behaviour to be more pronounced during periods of declining returns and rising
volatility. Our results align with the behavioural theory attributing the presence of common biases to intuitive judgements under
uncertainty (Tversky and Kahneman, 1974) and corroborating previous empirical findings that herding increases with volatility and
uncertainty (Chiang and Zheng, 2010; Demirer et al., 2010; Litimi et al., 2016).
Our findings are consistent with the overreaction and underreaction models of Daniel et al. (1998) and Barberis et al. (1998), the
limited rationality argument proposed in Hong and Stein (1999) and the limitations to arbitrage identified by Shleifer and Vishny
(1997) and De Long et al. (1990). However, limitations of cognitive resources leading to heuristic simplification (Hirshleifer, 2001),
a loss aversion bias (Tversky and Kahneman, 1991) and the recognition that a reference point or anchor influences an individual’s
decisions (Tversky and Kahneman, 1974), may have a role in explaining herd behaviour in particular in its beta herding form
consisting in following the performance of a readily available reference point, the market performance.
Overall, our results showing market return asymmetries conditional on herding states complement an extensive body of
literature documenting the predictability of stock returns and its state dependency. This evidence represents a further step towards
understanding herd behaviour and have important implications. To the extent that herding appears to be lack-of-information-driven
and increasing with market volatility and uncertainty, it allows policymakers to have a role in improving transparency, education
and information about markets and their constituents. Further work should be done to investigate the psychological factors driving
herd behaviour and to explore the conditions that affect factor returns conditional on herd behaviour.

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F. Costa et al. Research in International Business and Finance 68 (2024) 102163

CRediT authorship contribution statement

Filipe Costa: Participation in the concept, Design, Analysis, Writing, or revision of the manuscript. Natércia Fortuna:
Participation in the concept, Design, Analysis, Writing, or revision of the manuscript. Júlio Lobão: Participation in the concept,
Design, Analysis, Writing, or revision of the manuscript.

Data availability

Data will be made available on request.

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