Herding and contrarianism in financial markets produce informational inefficiencies when investors ignore their private information, instead following or bucking recent trends. I theoretically establish a preference-based link between the two behaviors: investors with prospect theory preferences follow one of the two strategies generically, depending only upon the relative strengths of their utility curvature and non-linearity in decision weights. The third aspect of prospect theory, loss aversion, further exacerbates informational efficiencies, causing traders to not trade at intermediate beliefs. Through a laboratory experiment, I provide strong evidence in support of the model's theoretical predictions and find that herding is by far more common than contrarianism.
Paul Woolley Research Initiative