Information Cascades in Capital Markets
Investors and managers in financial markets are often accused of making irrational investment decisions based on popular market trends, which can contribute to increased market volatility. An information cascade is one pathway by which poor investment decisions can permeate throughout a capital market. Information cascades occur when individuals observe the actions of others, and then base their subsequent actions solely on that observation – effectively ignoring the private information they have. This can cause information aggregation, on say a company in the market, to become extremely slow or even halted as investment decisions become based only on the action of others. This effect becomes exacerbated in capital markets as public information (i.e. who is investing in what stocks) becomes more readily available to market investors. The main problems with these cascades is that they place a high degree of importance on the analysis of initial investors, and they lead other market investors to ignore their private information – even if it contradicted following the cascade. Naturally then, these information cascades can be very fragile if based on poor initial information, and a publicly observable shock (i.e. poor quarterly earnings results for a company), can lead them to become dislodged. This can introduce a significant amount volatility in the market as people react suddenly to the new information. The significance of the referenced article is that it identifies common situations in which information cascades are likely to occur in capital markets, and the approach market investors should have when dealing with stock potentially affected by an information cascade.
The most intuitive example of an information cascade in the market is when a well-known investor’s endorsement of a company leads other investors to invest in that company – regardless of their previously accumulated private information. This is often referred to as the endorsement effect, and it accounts for the price rise in stocks seen shortly after, for example, Warren Buffet decides to invest in a particular stock. The second situation in which an information cascade occurs is when market analysts and investors cannot disentangle a firm’s accounting. When investors cannot make sense of a company’s accounting reports, the tendency is for investors to follow the investment decisions of other market players; this also holds true in the case when private information on a company becomes hard to interpret or gives mixed signals. The third situation in which a cascade develops is when a publicly observable shock dislodges a previous information cascade. An example of this is when a company’s earnings report does not support the analysis of the initial investors responsible for the investment cascade, which subsequently leads stakeholders to sell their position in the company. Investors not part of the original cascade, but invested in the company, can then start a new cascade in which they sell their position in response to the large number of short sales of the company. Finally, the referenced article also identifies investment company policy as often catering to the development of information cascades. Investment firms that are particularly concerned with preserving a reputation will often reward managers who deviate less from the market expectations. Thus, certain investment firms may base their investment decisions on market expectations rather than their private information; this holds true so long as the precision off the private information is in doubt. Similar reasoning also applies to younger managers who are looking to build a reputation and select more conventional portfolios that have lower risk.
This article concludes by describing investor strategy when information cascades are present, as well as strategy on how companies can benefit from said cascades. If a market cascade is perceived in a particular stock, investors are advised to avoid the stock all together or heavily monitor price changes that could indicate public shock. This is important even if the company’s fundamentals were good prior to the cascade – as the information cascade could lead to volatile price swings not indicative of the company’s fundamentals. On the other hand, companies can use cascades to their advantage by setting their stock price as undervalued. This will lead to an influx of investors and potentially to an endorsement effect from a big-name investor. The result could very well be a cascade in which the price of the stock outpaces the true valuation of the company.
Source Article: http://sites.uci.edu/dhirshle/files/2011/02/Herd-Behaviour-and-Cascading-in-Capital-Markets-a-Review-and-Synthesis.pdf