Information Cascades proven to have Real Life Consequences
The stock market world is one filled with uncertainty; what stock prices will go up tomorrow and which will go down? Should I buy more stock right now, or sell what I already own? There are numerous ways to analyze companies in order to pick the right stocks at the right time; some people even devote their entire lives to these such analyses. However, there is no right answer to any of these questions—there is no right way to predict direction of the stock market.
Most people who invest in stocks are not fully qualified to conduct equity reports or to do a Discounted Cashflow Statement. As a result, most people who invest in the stock market often rely on what they hear from others (whether that be a neighbor or a stockbroker). Now, with this statement, we can show how an information cascade can occur in the financial markets.
Let us recall first how and why information cascades occur. In general, an information cascade occurs when a person makes a decision regardless of their own observations or information. In the example we saw in class, when the first two people picked a blue marble at random out of a jar filled with both blue and red marbles, the third person guessed that the jar was majority filled with blue marbles regardless of what they saw. This scenario can help model how people across the country pick stocks. Let us for example say that you have two neighbors—Sam and John—that consistently invest in the stock market and claim to be somewhat knowledgeable in this field. Now, both John and Sam come running to you to tell you about this great new stock that you should invest in immediately. Even if you have your doubts, you chose to invest in the stock anyways, because their two good opinions of the stock (which mirror our High signals in our class example) are at a majority to your opinion—no matter what you pick. Now, John and Sam go around your neighborhood and tell the rest of your neighbors the same story; like you, the rest of your neighbors follow and invest in the stock since Sam and John’s two good opinions will always be a majority.
As you can see, these two small opinions caused an information cascade; however, unlike our situation in class, this information cascade can be proven to have major consequences. What happens if John and Sam actually had a minority opinion, and most people believed that the stock was a bad investment? Countless families could lose their earnings and savings through this fatal error. Thus, information cascades are not something to be taken lightly—they can have real life consequences throughout the social networks that are tied to the financial markets.
Source: https://www.investopedia.com/articles/investing/052715/guide-understanding-information-cascades.asp