Information Cascades and the Efficient Market Hypothesis
According to the Efficient Market Hypothesis, the market prices of traded assets such as stocks reflect their true value as the market mechanism helps all publicly available past and current information to be absorbed by the prices. There are strong, semi-strong, and weak forms of this hypothesis based on the types of information absorbed by the prices. For example, the strong form states that even the insider information only available to a small group of affiliates is reflected by the price. However, after having learned about the information cascades in class, I start to doubt whether the stock prices really reflect the information about the stocks’ true value. The price of a stock rises when the demand for the stock goes up, but if people want this stock simply because others seems to want it, then the price does not reflect genuine information about the stock. Hence, the question I try to address in terms of information cascades is, is the market price really reflective of the stock’s true value?
The study described in the paper by Tila and Porter examines the ability of individuals and groups to forecast stocks’ true value. One of the results shows that individual prediction is better than the group prediction. This can be well traced back to the principle of information cascades. Information cascades can be wrong, as we learned in class, because the behavior of people is not based on the reliable amount of genuine information. So their results from the study raise doubt about the efficient market hypothesis. If the effect of information cascades is not trivial, then the market price of the stock would not reflect its true value, since the majority of the people who purchased the stock probably imitated what the other people did before them.
How could the information cascades be prevented from entering the market forces? If every individual is equipped with a complete picture about the stocks’ value and importantly, faith in the information that they have, then there would be no need for having to see what others’ do. Information cascades occur because one believes that others’ behavior is based on some information that he or she doesn’t know. However, it is a bit unrealistic to banish all influence from seeing others’ decisions. The effect of information cascades cannot be completely eliminated, but I believe to some extent, it can be remedied.
Source: http://www.chapman.edu/ESI/wp/Porter_GroupPredictionInformationMarkets.pdf
-kay