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The Impact of Herding and Information Cascades on the Stock Market

Many modern economists believe that the stock market is both competitive and efficient. In a competitive market, no single person or entity (through their market power alone) should be capable of changing the price of any individual stock. Additionally, market efficiency, in regards to the stock market, implies that the prices of individual stocks are reflected by publicly available information. Therefore, any information that is available to the public domain should effectively “price-in” any stock. This also implies that no one person should have a competitive advantage in the stock market unless they have access to undisclosed information (i.e. insider trading), an illegal practice. These two characteristics would suggest that the stock market offers an efficient allocation of potential capital gains derived from equity investment strategies. After all, with no single person having a competitive edge in the market, there should be no potential investment strategies that leave a person strictly better off without negatively impacting someone else in the market. However, with the advent of the Internet and evolution of media, information has become increasingly transparent and can now be easily dispersed. Because of this, we can easily observe how network mechanisms such as information cascades can lead to irregular market valuations.

Many investors believe there are two forms of company valuation in the stock market: the firm foundation theory and “the castle in the air” theory. The firm foundation is based on the principle that a firm’s value is derived from the total value of all its future cash inflows over the future. This is, of course, the traditional sense of how many value of a company. After all, a firm should only worth as much as the profit it can generate for you. Using this model, a valuation is derived for a company, which can be used to calculate the value of the stock price (simply by dividing the calculated valuation by the number of outstanding shares). If the calculated “fair” share price is less than the market price, this company is considered “unvalued” and should be purchased for a profit. However, the castle in the sky theory brings in a new element into the stock market game. The concept is based on the “greater fool theory”, which simply states that stock values are not based on the firm’s intrinsic value (firm foundation). Rather, the value of a stock is based on how much it can be sold for to a “greater fool” who is under the influence irrational expectations of the market.

Oftentimes, stock prices may rise well beyond their actual intrinsic value because of the herd mentality of the market. When a particular stock price abruptly spikes upward, it signifies that the demand for shares far exceeds the sellers. Therefore, it often clouds individual investors’ judgment, making them believe a stock is worth more than it actually is. The price spike can be viewed as the “positive signal” in the cascade model, highlighting that this stock was perceived as a good value investment by several other investors. This leads many individual investors to follow the signal and also purchase the stock, further driving the price higher, akin to a self-fulfilling prophecy. The same principle works in the opposite case. When share prices decline abruptly, it sends a “negative signal” to investors that signifies that the respective stock is a poor investment and should be sold. These principles have led to the rise of momentum trading, where some traders attempt to exploit sudden swings in the market to their advantage. Although single investors cannot individually alter stock prices (market-competitiveness), a “herd” of irrational investors certainly can.

The dot-com bubble is an excellent example of the impact of information cascades and herding in the stock market. During the late 90s and early 2000s, as the internet was building an ever-growing presence in the world, many saw the potential impact the world wide web would have on companies’ abilities generate revenue. This led to wild speculation, where many newly formed public internet companies were being sold on the stock exchange for exorbitant values. Companies that generated little to no revenue were suddenly valued highly. Individual investors would receive positive signals (i.e. surges in stock prices of various companies), leading them to believe that these stocks were sound financial investments. This led to even further swelling of the “bubble”, as stock market indices such as the NASDAQ and DJIA reached all-time highs. Like all bubbles, however, this one eventually burst as investors soon realized they were disillusioned by irrational herd mentality. As people began to realize these companies’ “true values”, market prices quickly declined causing investors to lose millions due to speculation.

Despite popular belief, the prices of the stock market are not simply governed by the values of the underlying firms. Rather, there is a very clear network effect that causes shares to rise or fall. By understanding the impact of information cascades, investors can better understand the causes for price changes and avoid making poor investment decisions based on the irrationality of others.

Sources:

Malkiel, Burton Gordon. A Random Walk down Wall Street: The Time-tested Strategy for Successful Investing. [9th ed. New York: W.W. Norton, 2007. Print.

Stiglitz, Joseph E. The Allocation Role of the Stock Market The Journal of Finance

http://www.cs.cornell.edu/home/kleinber/networks-book/networks-book-ch16.pdf

http://mpra.ub.uni-muenchen.de/20217/1/MPRA_paper_20217.pdf

http://www.investopedia.com/terms/h/herdinstinct.asp

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