Information Cascade, Momentum in Stock Market, and Bubbles
In the information cascade model, people that make decisions early can have a dominating effect on public opinion. In essence, the early deciders’ private information is overvalued, and the later deciders’ is undervalued. Is it good or bad?
In the real world, experts usually have more and better private information and are better able to draw the correct conclusion from their private information. Therefore, it is practical for the crowd to wait for the experts’ opinions and then to simply follow them. While the followers can benefit from information cascade, the experts can also use this phenomenon to take advantage of the followers. In the stock market, this often happens.
Imagine a market with 1 professional investor and 100 average people. The investor does his analysis and predicts that the stock of Red company will go up, so he buys Red’s stock. The 1st average person also believes that Red will do well, and the investor’s action confirms his belief, so he buys Red’s stock too. The 2nd average person does the same thing. Note that when people buy a stock, they also raise its price, making it less profitable for the next person to buy the same stock. Assume that by the 80th person, the stock price is at its reasonable level, that is, it will be unprofitable for the next person to buy it. However, the 81st person does not know the reasonable price of Red’s stock. Under the influence of information cascade, he buys the stock too. The same thing happens to the remaining 19 people. This phenomenon is called the Momentum Effect in stock market. It explains how the diffusion of information leads to stocks’ being constantly overvalued or, if the investor initially decides to sell a stock, undervalued.
The story does not end here. When the 81st person buys the stock, what does the investor do? The investor knows the reasonable price of that stock, otherwise he would not have bought it. Now that the stock is overvalued, can he signal people to not buy it anymore? Possibly. Although it takes at least two people to reverse an information cascade, the investor’s signal has more authority than an average person’s. On the other hand, what happens if he does not signal the market? The 81st-99th persons will continue to buy the stock, pushing its price to an unreasonably high level. Then, the investor sells his share to the 100th person, making a huge profit and leaving the 100 average people to deal with the consequences. In summary, the professional investor has the ability to start an information cascade and, being the early investor, can rip a huge profit when the stock is overvalued, so he has incentives to not stop the information cascade and let people inflate Red’s price.
This is why smart money, comprised of venture capital firms, private equity firms, and investment banks, do not warn people of bubbles and, instead, often encourage people to buy more right before the bubble bursts.