Information Cascades in the Stock Market
One topic that we have discussed in lecture that has many practical applications is the information cascade. An information cascade is when a person makes a decision based on the previous decisions of others rather than on his or her own opinion. The example discussed during class was that if many people are in a restaurant, it is likely that any given person will also go to that restaurant solely because they can see that many other people have made the same decision and the random person will follow the mass. This does not mean that the restaurant is any better than another, even if another restaurant has no one inside. The empty restaurant could be twice as good as the crowded one, but the concept of an information cascade explains that people will choose the crowded one, and even if they believe a less crowded one may have better food, they will follow the crowd.
This trend can often be seen in the stock market. There are certain leaders, such as Warren Buffett of Berkshire Hathaway, that can begin a trend in the market and influence prices. To begin, a stock’s price should in its simplest form be the present value of all expected future dividends on that stock. However, in the market, some factors such as demand will be able to shift prices. When a leader or perceived expert buys a stock, other investors will perceive it as a good investment and demand for that stock will increase. This creates a sort of cascade. Once Warren Buffett bought stock in Exxon Mobil, other investors assumed that it might be a good investment and at first, a few investors would make the same decision as Warren Buffett and then this created a spike in demand for stock in Exxon Mobil. This spike was visible to all investors in the market, and slowly more and more people began buying the stock. This trend inflates the price of the stock simply due to an increase in demand because now everyone wants to buy stock in Exxon Mobile, and basic economics explains that when there is a higher demand, the price should increase. Now, the price is no longer equal to the present value of the future dividends because it has been inflated due to demand. Eventually this inflation will be corrected, but it is an excellent example of how there can be a brief information cascade in the stock market that influences prices.
You can read more about how Warren Buffett’s purchase of Exxon Mobil stock affected its price below:
http://finance.yahoo.com/news/why-market-cares-warren-buffett-172450192.html