Information Cascades in the Stock Market
https://www.economist.com/democracy-in-america/2011/10/26/information-cascades
This Economist article discusses the effects of information cascades on several real-life events, most notably the stock price of Netflix in 2011.
The general notion behind information cascades is that people will often imitate the actions of their peers, often for a variety of reasons. Some people think others are more knowledgeable about certain topics, or are simply too afraid to make a choice that will make them stand out. Either way, there is agreement that the actions of people have a powerful influence on the actions of those surrounding them. In class, we learned about how people sometimes make choices that directly conflict with the evidence they are given because they know that other people made different decisions (i.e. the marble game). Once an idea is accepted by enough people, no matter what contradicting evidence they have, they will always follow the crowd. This idea has become known as an information cascade, and occurs when people blindly support an idea even if there is weak evidence for it being true.
Although this article is several years old, it examines some still relevant phenomena, and can be useful predicting future outcomes. The first story the article explores is the volatility of Netflix’ stock price in 2010-2011. Netflix stock price was soaring in late 2010 and early 2011, and people kept buying, until the stock tanked halfway through the year. The author of this article found that the price of the stock actually had very little to do with the internal affairs of Netflix, and a lot to do with the stock market’s perception of the company. Because so many people were confident in the stock and kept buying it, other stock traders were inspired to buy the stock, and all this confidence in Netflix continuously increased the stock price until it was overvalued. The stock price reached its tipping point when Netflix increased its membership price and changed the types of deals it offered. Once this happened, the stock price dropped drastically, and shareholders immediately lost faith in the company. At the time, Netflix was mostly in the DVD-by-mail business, sending members movies a couple days after they ordered them. At this point, however, Netflix began to change into a streaming service, where they would purchase the rights to stream films from producers and allow users to have instant access to them. Although in hindsight this was clearly a good decision for Netflix, as it is currently very popular, some stockholders did not think it would be, and the same phenomenon that caused Netflix’ stock price to soar also caused it to drop 77% in 4 months (https://www.cnet.com/news/netflixs-lost-year-the-inside-story-of-the-price-hike-train-wreck/). Once Netflix increased its membership fees, its stock dipped, investors lost faith, and many shareholders followed suit by dumping their Netflix shares and driving the price back down. The Netflix story is relevant today because stock prices still sometimes follow the same pattern – confidence in the company drives the stock price up until the company is overvalued, then a lack of confidence can drive the price right back down. It also goes to show the influence that information cascades can have in the real world. Millions of dollars changed hands because people just copied the actions of their peers without doing research to find their own evidence and draw their own conclusions, and this can still happen today. Information cascades can be either positive or negative, but it is important that people educate themselves so they don’t contribute to a potentially harmful cascade by blindly following the crowd.