Herding and financial panics: a role for cognitive psychology?

The purpose of this Research Memorandum is to assess whether concepts from psychological theory may be useful in explaining herding and crises in financial markets. The conclusion is that the theory of cognitive dissonance, which assumes that the human brain seeks and processes information in a biased way, seems to be able to explain both phenomena. A possible policy implication is, that intensive and careful information dissemination may be important both for socially optimal investor behaviour and in creating financial stability.