Cascading in Capital Markets
Cascading in Capital Markets
It is within human nature to dictate our decisions and and actions based upon a variety of factors, most importantly the information observed and received from others. Cascading, or herd behavior, is most explicitly seen in its pure form in capital markets when quick decisions and predictions about the future need to be made based upon a scarce amount of information. A decision contains a large amount of randomness, it is seemingly typical, and almost instinctual to follow the decisions of the large players and influencers such as Warren Buffet, in hopes of not missing out on a potential big win, or very damaging loss. Cascading in capital markets can occur in three forms: information based herding, reputation based herding, and compensation-based herding. All three forms are the main reasons there might exist any form of cascading when it comes to investing and the stock market.
Information based herding occurs when individuals react in the same way to information that has been announced to the market. This form of herding occurs quickly and can be described and analyzed through the discussions had in lectures. For example, suppose that there exists investors who are considering purchasing stocks from a company. Each individual maintains private information (signals) that no one knows and initially may make decisions based upon that private information. If investor A observed Good they will invest and if the other investors see investor A invest they will assume he observed Good and invest as well. This goes to show how quickly information cascades can occur, however, this form of cascading can also change quickly when new, potentially false, information arises. Suppose investor A observes Good, investor B observes Good, investor C observed Bad, and Investor D observed Bad. Then Investor F will still invest because the first two initial investors observed Good and most likely invested. However if the sequence of information came in as BBGG then investor F will not invest because a cascade already began with the first couple of investors. This once again reaffirms the idiosyncrasy of such markets and its lack of robustness as new information and the sequence in which information is received can greatly alter the populations interaction with the market.
Another form of cascading behavior is due to reputation based herding. This form of cascading is caused by a “respected investor or major trading house taking a specific trading stance.” This cascade occurs when investors take into their own abilities to predict correct outcomes about certain situations with high levels of uncertainties. If the investor is highly skilled versus low skilled they might follow their own signal versus follow the signal of someone who is an established well known investor, respectively. This can be seen with the cascading of individuals selling stocks for due to the pandemic because large companies and investors began selling stocks. To add on, this can also be seen when large players in the market began to invest in companies/countries they believe will eventually do very well and become profitable in the long run which explains the skyrocketing of Zoom and Pfizer.
Finally, the last form of cascading in markets occurs with compensation-based herding when certain conditions prompt large institutional money managers to take profits, generally to protect fund earnings and to improve their portfolio compared to others. The cascade begins when an influential market player sells stocks from a company that is doing well in an attempt to earn a profit for themselves, while for others this profit might not be reflected, it is a decision that is only beneficial to an individual with the same type of portfolio. The cascade begins when they sell and others begin to sell out of fear in reaction.
While capital markets go through different forms of cascading, these forms of shifts in a market full of risk are natural and overall beneficial to the economy. There may be long periods of stagnation and then sudden shifts within seconds that causes panic in all investors. Ultimately, cascading in our networks has proven to be beneficial in predicting the future of capital markets as we can reasonably assume that in the event that a situation happens a cascade may begin and this could be beneficial or destructive, as the market may crash and people may uniformly fear loss of stocks.
Sources:
- Duff, V. (2017, February 07). Herd Behavior in the Stock Market. Retrieved December 14, 2020, from https://finance.zacks.com/herd-behavior-stock-market-9833.html
- https://www.imf.org/external/pubs/ft/wp/2000/wp0048.pdf