Information Cascades in Financial Markets
An information cascade occurs when people, regardless of their individual insights, observe and then follow the actions of others. This phenomenon is common and is readily apparent in an array of different circumstances – one of which being the herd-like behavior of investors in financial markets.
Investors tend to follow the consensus and often tailor their investment decisions around the actions of others. Indeed, the market listens when a famous investor reveals a stake in a company or a sell-side analyst changes his or her recommendation on a stock. While such events are important and should be noted, they should never be followed blindly. Every analyst has their own reasons for recommending an investment and individual investors are often unaware of the conflicts that lead sell-side analysts to advocate the opinions that they do.
For example, the amount of “buys” far outnumbers the number of “sell” ratings because analysts seek to maintain good relationships with the companies they cover and don’t want to limit their access to management. Likewise, equity research firms are often contained in larger financial institutions that present additional conflicts of interest (e.g. brokerages that also provide investment banking). The investors who blindly follow these recommendations face the consequences of this asymmetry in information and are more inclined to underperform those who invest on their own insights. The presence of these types of information cascades help to contribute to bubbles, mispriced valuations, and other market failures.
Sources:
http://hbswk.hbs.edu/item/4430.html
http://www.investopedia.com/articles/01/013101.asp#ixzz2CLCbv74J
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