Information Cascade in the Financial Market
https://www.investopedia.com/terms/b/blacktuesday.asp
Information cascade refers to the phenomenon that people make decisions based on other people’s previous decisions. Often times people simply choose whatever the majority chooses, so called “follow the crowd”. The major reason is that people often do not trust their own judgements, especially when many other people believe and thus behave otherwise. Additionally, there are certain benefits for following the crowd. Direct benefit is created simply when more people make the same choice. For example, if many (enough) people enroll in a class, this class is guaranteed to be held and more students can study together. There is also information based benefits from learning other people’s choices. Use the same example, the fact that many students enroll in this class might convey information such as it is taught by a good professor.
Information cascade applies commonly in the financial market. For example, amateur investors usually do not trust their own judgement and believe people who work on Wall Street know better and thus simply copy their decisions on stocks. This can be beneficial to these amateur investors as if more people follow the same trend, demand for these certain stocks will increase and thus they can gain profit, the direct benefit. Also Wall Street traders might actually have better private knowledge than average amateur traders about these stocks so copying their choices are more profitable; this is information based benefits. Nevertheless, information cascade can cause drastic disaster as well: the infamous Black Tuesday, for instance. On that day in 1929, the New York Stock Exchange collapsed. Information cascade caused a chain of events and eventually led to this stock market collapse. In a decade, people keep investing more into the stock markets without thinking , because they observed everyone else was investing and making profits. As a result, stock prices rose to unprecedented levels. As the economy slowed down, this bubble eventually burst and the stock market suddenly crashed. This was only the beginning. People rushed to banks to withdraw their deposits because they realized everyone else was doing the same; if they did not withdraw, they would lose their savings as bankrupts happen. Therefore, banks exhausted their reserves and the government had to close the banks as America started the Great Depression.
As said, information cascade remains common in the financial market, and it can be a double-edged sword.