Information Mirages in Debt and Equity Markets
An interest in herding experiments is what presumably led a 2014 blogger to Anderson and Holt’s Information Cascade Experiments article. In the article, Anderson and Holt give a description of their blue-red urn experiment that can be found in chapter 16 of Crowds, and Markets: Reasoning about a Highly Connected World by David Easley and Jon Kleinberg. After their summary of the urn experiment, Anderson and Holt moved their discussion into one with a focus on market applications of information cascades. One experiment cited by Anderson and Holt found a relationship between the strength of signals and the amount of time the signal recipient waited before making a decision based on the signal. In their experiment, Bounmy, Verganud, Willinger, and Ziegelmeyer (1997) sent asset value signals to pairs of individuals. The signals indicated either to buy the asset, sell it, or do nothing. The signals could have also been strong or weak. The researchers observed that individuals with weak signals waited for their partner to make a move. Those with weak signals were comfortable coming to a decision only when they saw the decision their partner made. This is made more interesting by the fact that if an individual chose to wait, they incurred a small cost.
Anderson and Holt also cited Camerer and Weigelt’s 1991 study on information mirages and their impact on trading. In a market, there are both uninformed and inside traders. The uninformed traders know neither who the inside traders are nor what information they have. Despite this, uninformed traders can still try to glean information from the changes in stock prices. However, in the sessions run by Camerer and Weigelt, insiders were removed and only uninformed traders remained. This adjustment was unknown to the traders in the experiment and they continued their attempts to glean information from stock price changes. Eventually, some traders made errors in their trades. These errors were then observed by others as potential inside trades. Under this false notion, more trades were made. Camerer and Weigelt called this price path an information mirage because the path was created by an incorrect use of information. Anderson and Holt (2008) put it as: randomness by uninformed traders may result in incorrect cascades.
Cited by Camerer and Weigelt, Cornell and Shapiro (1989) compared the impacts that incorrect cascades had on debt and equity markets. Bonds, a popular debt instrument, have some degree of certainty around their cash flows and maturity dates. It is for this reason that “self-fulfilling expectations paths based on misperceptions of what the terminal date price of a bond will be” are impossible (Cornell, 1989, p. 310). In contrast, far more variables are used when determining whether or not an equity investment is sound. It is for this reason that equity markets may see more pricing anomalies like the self-fulfilling expectations paths.
References
Anderson, L. R., & Holt, C. A. (2008). Chapter 39 Information Cascade Experiments. In C. R. Plott & V. L. Smith (Eds.), Handbook of Experimental Economics Results (Vol. 1, pp. 335–343). Elsevier. https://doi.org/10.1016/S1574-0722(07)00039-X
Cornell, B., & Shapiro, A. (1989). The Mispricing of U.S. Treasury Bonds: A Case Study. The Review of Financial Studies, 2(3), 297-310. Retrieved from http://www.jstor.org/stable/2962162