Information Cascade and the Stock Market
http://finance.yahoo.com/blogs/breakout/rely-money-not-people-ben-stein-123520229.html
Activity in the stock market is dependent on many different factors ranging from financial performance to rumors. In the past few years, the stock market has been plagued by periods of unprecedented volatility. Volatility provides a measurement of the amplitude of price fluctuations higher values of volatility correspond to a riskier market. In the attached article, Ben Stein states that volatility “is going to crush the stock market as a vehicle of investment for the ordinary citizen… at least for a while.” If opportunity to invest in the stock market is only feasible for the elite class, then there are serious implications. The wealth gap will grow larger and social stability and mobility among middle and lower classes will be eliminated
Volatility can be analyzed through network theory. This provides insight that may someday lead to mechanisms to lessen volatility. There are a few basic assumptions to this argument: all investors try to maximize their earnings, the general direction of the economy is uncertain, and investors have access to the same public information (quarterly earnings, acquisitions, etc.), but not private information resulting from investors’ individual analyses and findings.
On any given day, an investment bank may make a stock investment in a certain entity based on research and quantitative models in hopes of creating a profit. It is likely that other investment banks will have conducted similar research and will have arrived at the conclusion that they too should invest in the same entity. As a result of investments from the big players on Wall Street, the stock price will inevitably increase. It is at this point when an information cascade can occur in an uncertain environment.
More casual investors with limited capital to invest in research understand that if there were significant investments in an entity at a specified price, then investing in the same stock at a slightly higher price would also be wise. With such an uncertain outlook on the economy, these investors will trust other people’s actions over their own intuition and research. The same methodology is used by slower reacting investors which pushes the stock price up further. Besides the initial few investments, the stock price increased due to investments made because investors believed that since someone bought the stock at a slightly lower price, it is still a good investment at the current price. Eventually, investors with sophisticated quantitative research realize that the stock price is overinflated and sells their shares. The reverse of the initial buying cycle occurs and a cascade will occur where many investors sell their stocks.
With this argument, only the investors with the greatest research capabilities and best quantitative models will be able to succeed in the stock market because they are able to identify the initial opportunity and take advantage of the herding effect. Now that a theory of why volatility exists, the next step is to identify solutions. If the cause of volatility in the stock market can be simply explained by network theory, could research in network theory and information cascade decrease or eliminate the serious threat of volatility that discourages investment from ordinary citizens?