Information Cascade in the Financial Market
https://quantdare.com/the-herd-effect-in-financial-markets/
This article talks about the effect of information cascade in the financial market. On a daily basis, investors receive imperfect signals on the future of a stock, indicating whether this stock will rise or fall. This article highlights the process in which an information cascade may start in the financial market. There are three investors: I1, I2, and I3. For a stock, if I1 purchases and I2 purchases, then I3 will purchases independent of his personal signal. Furthermore, if I1 does not purchase and I2 does not purchase, then I3 will not purchase independent of his personal signal. However, if I1 and I2 make contradictory decisions, then I3 will make decision to purchase based on his own signal. However, this information cascade model can actually do more harm than help. In numerous cases, this “herd behavior” may not provide sound investment strategy, because often times the latest investment trend may not be the best strategy, contrary to what the general public believes.
This relates to our discussion in the lecture on information cascade and how prior decisions can affect current decisions. Given a bag of marbles, there are two possibilities for the bag – majority blue and majority red. There is a line of students trying to guess whether the bag is majority blue or majority red based on the marble he picks from the bag and the guesses of the previous students. Assume that the first student picks a blue marble and guesses majority blue and the second student picks a blue marble and guesses majority blue, then the third student and the students after him will guess majority blue regardless of what color marble they actually picks. This is a perfect example of information cascade. Even if all the students after the second student picks a red marble, they will all still guess majority blue because they will follow the previous trend, which in this case is misinformation.