Can Information Cascades Lead to Financial Bubbles?
After the financial crisis of 2008, many people were asking the same question: how did experts not identify the bubble forming in the housing market? In hindsight, it is easy to see how irrational investors were in ignoring the risks they were taking on in the marketplace. However, it is difficult to explain why such irrationality prevailed. Cascade theory is perhaps the most reasonable explanation for such a phenomenon. In 1992, economists Sushil Bikhchandani, David Hirshleifer and Ivo Welch calculated that, assuming each individual has information that is 60 percent accurate, the probability of an information cascade leading to an incorrect conclusion is 37 precent.
It is extremely difficult and time-consuming for any individual to evaluate the risk of real estate investments, and on Wall Street where salaries are high, every second spent analyzing such information costs a lot of money. It is thus rational to take into account the information that other people are giving about the market. Even if that information is based on incorrect conclusions, such as real estate being of high investment value, it is a strong signal.
However, this explanation does have certain flaws. Theoretically, prices of financial instruments move to disincentive herd behavior. The more people buy, the more expensive it becomes to buy. The fewer people buy, the cheaper it becomes to buy. Investors are supposed to buy based on valuation, not based on what other people are doing. However, people are not always rational and our natural instinct to follow the crowd definitely could have played a role in the universal fantasy that housing prices could rise forever.
It is also important to note that it can be rational for investors to buy in a bubble market, as long as their strategy involves equity extraction. In this case, an information cascade would only partially explain why the bubble grew so big.
http://www.nytimes.com/2008/03/02/business/02view.html?pagewanted=1&_r=2
http://object.cato.org/sites/cato.org/files/serials/files/regulation/2003/12/v26n4-2.pdf