Information Cascade and Mutual Fund
Information Cascade is frequently associated with the irrationalities in the financial markets, notably the market crises and bubbles. In fact, information cascade has much more influence on the financial markets. It influences the allocation of billions if not trillions of assets regularly. According to a research report from the University of Pittsburg, mutual fund managers may be influenced by information cascade when they select and update their asset portfolios.
Mutual Funds are investment vehicles where money managers invest in a range of securities using the pool of funds collected from many smaller investors. The money managers are tasked with selecting the securities with the best value and potential while balancing the portfolio risks. They often put in vast amount of resources and efforts in researching the securities to come up with the portfolio composed of a variety of assets. Considering the numerous equities, fixed income and other asset class options in the markets, it is reasonable to conclude that every mutual fund should be distinct. However, the report points out that these managers often form portfolios similar to their peers’, and one of the major reasons is information cascade.
Some might argue that these managers all believe that the selected securities have the best investment prospects, given the available market information. However, another likely reason would be information cascade. Sometimes, even though the managers hold a different opinion about certain equities, bonds or commodities, they tend to follow the market consensus. The managers would rather stay safe by following their peers as they suspect that their peers possess extra information. The mangers tend to avoid exposing themselves to the risks of getting on the wrong side of the market. One of the rationale behind this is career concern. These managers try to be in line with their peers so that they do not have to risk their own careers. When the managers follow one another and result in investment loss, the managers will not be blamed alone.
However, in fact, in most of the cases, information cascade does not serve the mutual fund well. Assuming the market is efficient, with the managers following general market consensus, the profit margin will be very low. The research also observes that managers who tend to follow their peers’ portfolio selection are likely to receive a lower investment return as compared to those that believe their own ideas. This once again confirms the notion that to excel in the financial markets, one has to be a contrarian, or at least to believe and act on one’s individual investment thesis.
Source: http://business.pitt.edu/katz/sites/default/files/koch1.pdf