Market memory, advance reaction, and retail investor herding

Abstract

The arrival of new information, in conjunction with investor cognitive biases, has commonly been acknowledged as the main cause of herding behavior. However, whether past market information embedded in market memory influences investor herding has been less explored. We utilize tick-level trading data from the Chinese stock market to examine the impact of the market memory formed of stocks' exceptional performance during their initial trading days on the future herding behavior of retail investors. The empirical results show that the market memory of newly listed stocks is positively correlated with retail investor herding one year later at the appearance of a market-wide upward trend. We also propose an advance reaction channel in which retail investors tend to pay early attention to and preemptively invest in stocks with deep market memory due to their limited attention and the availability heuristic, leading to further herding due to confirmation bias. Our findings show that market information, if not fully incorporated into current stock prices through investor trading, can be partly stored in market memory. When activated by specific market conditions, market memory can be recalled and affect investor behavior and subsequent price dynamics. Our findings provide additional evidence to challenge the efficient market hypothesis (EMH) from the perspective of behavioral finance.