Information Cascades in Investing
Link:
https://www.gsb.stanford.edu/insights/where-stock-market-psychology-pricing-intersect
Investors in the today’s stock market have a wealth of information on which to base their decision to buy, hold, or sell. For example, a typical investor might decide based on indicators of the company’s value, such as an earnings statement or a balance sheet. However, sometimes the price of a stock moves in ways that makes zero sense when analyzed in terms of the company’s value.
Take the case of the company Palm for example. Palm was spun-off of its parent company, 3Com Corporation, and debuted in its IPO at the height of the dot-com bubble. Prices soared, and eventually Palm’s valuation far surpassed that of 3Com, despite the fact that 3Com owned 94 percent of Palm. If we were to analyze the value of 3Com, this would make little sense. If Palm is valued so highly as a company, why is that value not reflected in the price of 3Com?
Perhaps information cascades can provide an answer. Let’s think of Palm stock as having two states: Rising or Falling. Each individual investor would then receive a signal, which we can think of in this context as the investor’s individual opinion on whether the price will move Up or Down, based on the information he knows about the company. For example, if an investor sees a news article that says Palm is doomed therefore forms a negative opinion of Palm’s future, we will say that investor received a Down signal. Finally, based on his signal, and the decisions of other investors to Buy or Sell, the investor will make his own decision to Buy or Sell.
Now consider the case of an astute investor who noticed that Palm’s value has surpassed that of it’s parent company 3Com. If he were ‘rational’, he might sell his shares, as this information is indication that Palm is overvalued. This investor thus received a Down signal. However, he also notices that the price of Palm continues to rise. From supply and demand, this means that there are more and more investors who are trying to Buy. Then based on the principle of information cascades, this means that the probability that Palm’s state is Rising is high, and the investor should disregard his own signal and just follow the cascade. Thus the investor still decides to Buy, despite himself believing the stock is overvalued, and thus continues the cascade of Buy decisions.
This shows that information cascades might be able to explain how Palm’s price became unreasonably high based on a few initial investors deciding to Buy. Clearly, investors cannot simply make their decision rationally based on evidence, but must also take into account the behaviors of others in the market.
nice post!