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Why Information Cascades and Financial Markets Don’t Mix Well

In his article, “Forward and Falsely Induced Reverse Information Cascades”, Michael Seiler focuses on information cascades in the context of real estate. Seiler investigates the behavior of a group of university students (who represent the average person with little knowledge of the real estate market) when confronted with a hypothetical problem: would they resign a lease if they knew that their landlord stopped paying the mortgage on the rental property, and thus may be evicted during their next leasing period? Seiler investigated the likelihood of students resigning their leases if the rent was changed (both lower and higher). To investigate the possibility of information cascades, the survey was conducted twice on the same group of students: the first time around, responses were collected individually, with students unable to see the responses of other students. The second time around, students could see other students’ responses as they answered. The survey was also divided into Parts A and B: in Part A, the student had no special relationship with their landlord, while in Part B, the student was close friends with their landlord. However, in Part B, false group results were shown to the students to measure whether or not individuals changed their behavior in order to follow the crowd. Seiler finds that students tend to follow the behaviors of those of those around them, demonstrating the powerful effects of information cascades.

Information cascades are prevalent in many financial markets, including real estate and the stock market. Financial crises like the 2008 US housing market crash are caused by what Seiler calls reverse information cascades- cascades where individuals “discount their more accurate private information and follow the herd in the wrong direction” (226). In the case of the housing crisis, home prices inflated as a result of a reverse cascade and the crash was a result of prices reverting back to their market values. Seiler’s study shows that in groups of people with little-to-no knowledge of real estate markets, people tend to follow the behavior of others, despite what they may personally believe. Similar situations have happened frequently in the past, such as the Wall Street Crash of 1929, the Panic of 1837, and even Tulip Mania in the 17th century. Reverse information cascades like these can have devastating effects on the economy, yet history has proven that they will happen again and again.

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November 2014