Buy or Sell? What did the Analysts Say?
Business seems to be booming, and it is an overall prosperous time as the economy continues to trend upwards. You have a couple of friends who recently purchased some dot com stocks and they seem to be doing pretty well. You follow suit and purchase some as well without doing intensive research: based off of the overall market health and the upward trends, you think you have a relatively low risk in the transaction. This is a small example of information cascade. However, the ordinary stock market is usually heterogenous – everyone has different reasons of buying and selling stock. For example, Dequavius wants to get into investing and learn more about the market, so he places a pool of money in Apple to evaluate his performance. On the other hand, Gengar wants to sell all of his stock because he needs most or all of his original investment including gains and losses to repair his car transmission. None of these transactions are right or wrong in any way and the reasons have absolutely no relations to each other. Professional investors and analysts also have their own ways of evaluating a stock without outside influence, using indicators such as simple moving averages and relative strength indexes to help make their decisions. But the stock market isn’t always in a constant state because there are booms and busts. During the dot com example above, investors continued to buy copious amounts of the dot com stock because everybody was optimistic about it. When the stock becomes overbought and starts losing its value during a bust, a few sells and rating downgrades by credible sources such as investment banks caused a panic attack for the rest of the world. As a result, everybody sold the stock and it eventually lost all of its valuation. The reason the stock market is so volatile is because many traders in the stock market are the average Joe who may not have the time to do intensive research like professional analysts. These ordinary traders are more prone to follow what everybody else is doing because they do not trust their analysis as much as how the market is moving.
The stock market is essentially an application of the information cascade theory. Normally, investors follow their own analysis and act upon their own decisions, while ordinary traders are more prone to following an information cascade from well-established investment banks and analysts. For example, if there are 2 analyst ratings on a specific stock and both of them state that the stock is a strong buy, then more people would likely buy the stock because of this information, especially if their own evaluations match with the analysts. Furthermore, if the stock market is in extreme turmoil like the housing crisis of 2008, everybody panics if a few investment banks declare a specific stock worthless for example. This creates a situation on a much larger scale: investment banks may follow other investment banks’ decisions and create an information cascade on a global level.