Information Cascades and Finance
This article addresses the impact of information cascade on stock prices and other financial constructs. The article uses Netflix as an example of how when a stock is doing well and constantly increase in price, people invest in it and others stock shorting it. When less people short a stock, it is easier for the price to increase, since there are essentially less shares to buy. But, once a few people started having success shorting the stock, more people tend to test their luck shorting the stock, decreasing the likelihood that the stock price will go up. This type of reinforcement in which people buying the stock because it goes up and shorting or selling the stock when it goes down, creates large swings in stock price and where people end up following the actions of others. In this case it caused Netflix stock to rise very fast and then fall a significant amount. Another example used in this article is the meeting between government leaders in the European discussing how to solve the issue of negative information being spread about the debt of some of the Southern European nations. Similar to the Netflix stocks, when people start having success shorting government debt, more people begin to short the debt. However in this case, it can have severe negative impact on the financial security of the nation. In turn making it even more likely for their debt to be shorted which can continue and produce catastrophic results.
The concept of information cascades in the financial district is what caused both the stock market crash in 1929 and the housing crisis in 2008. In the housing crisis, people were making profit investing in real estate and houses so more and more were investing, which increased the value of the investments, since many people were looking to purchases houses to then resell. Since so many people were looking to purchase homes, to then flip, the value of homes during this time increased. Once people started wanted to sell their houses, the perceived value for these house fell to the wayside and the large disproportion of supply and demand for houses on the market caused the market to crash. In finance class we learn different ways to estimate what a fair price for a stock is. These estimates use tangible figures, such as net income or cash flow. We see in this article how information cascades can skew markets based on people following the decisions of others, causing the value of different assets to diverge from their true value, and potentially leading to catastrophic results.
https://www.economist.com/democracy-in-america/2011/10/26/information-cascades