Herd Induced by Uninformed Traders in Efficient Financial Markets

Rational herd is usually regarded to be difficult, if not impossible, to take place in an efficient financial market. In an extension of a sequential unit trading model, we find that large numbers of inferiorly informed traders who used not to trade could be induced to engage in herding when there are only a few uninformed traders adopting feedback strategies. We show conditions under which different scenarios take place. The herding led by uninformed traders could be persistent and robust without information cascade. The model also captures the gradual accumulation of market frenzies and panics. As the required number of uninformed traders who trigger the informed trader’s herding could be very small, the model is plausibly justified in reality. The model thus provides us with a unique framework for looking into many interesting phenomena in financial markets.