Prospect theory and the irrational herding in stock markets

We study investors' herding behavior in the stock market by examining their dynamic portfolio choices with the prospect-type utility. The idea that people care about changes in the financial wealth rather than final wealth positions and that they are risk averse over gains and risk loving over losses can substantially affect their investing strategies and herding attitude over time. Using the concept of value function suggested by Kahneman and Tversky (1979,1992), we are able to track informed as well as uninformed investors' investment decision and predict the occurrence of herding where informed traders disregard their private information. Finally we investigate how the existence of institutional investors who are more likely to be risk neutral than noisy traders affects the likelihood of herding in the stock market.