Information Cascade in Financial Market
Information cascade is a phenomenon that can be seen everywhere in our daily lives- from small things like raising your hand after the majority choice when you don’t know the answer, to big things like getting involved in investment because of the words of a few people with authority. The use of information cascades in financial markets becomes behavioral economics, which can be used for both good and bad effects.
In the “Understanding Information Cascades in Financial Markets” written by Barclay Palmer, the basic mechanism of the information cascade is explained. Given the context that there is nondirect communication among people if the first two decision-makers decide to accept based on their knowledge, the subsequent people who can see the decisions made by the first two persons may then follow their decisions of accepting, disregarding their knowledge of the event. Once a group of people falls into the information cascade, there will be little useful information added to the crowd by observing the decisions made.
In financial markets, the characteristics of the information cascade can harm investors. If a few financial pundits make the same decision, then an ordinary investor who has the information about the financial pundits’ decision may neglect their independent and autonomous judgment and follow their decision. However, in addition to the possibility of illegal manipulation of the stock market, the stock market itself is also volatile, and there is no guarantee that the next moment this decision is still applicable to the market.
I couldn’t agree more with this article. As an investment whiz, I briefly entered the stock market in China when it was very good for a while. However, because I don’t have any professional knowledge per se, I usually get my information from friends or family on which stock I should choose. Usually, my friends and family are not professional people in this area, they tend to get their information from some inside sources or from people who have made good investment returns in the past. In an even more outrageous case, I followed many financial accounts on a social media platform, Little Red Book, and those people added credibility by showing their past returns, plus people in the comments repeatedly mentioned that they had made a lot of money after reading what these financial accounts shared. This made me believe in a certain account so much that when he occasionally gave out “benefits” and gave a stock ticker that was about to skyrocket, I put 30% of my principal into the stock. Every time someone asked in the comment section when the stock would go up, he reassured us that we should be patient, until one day I found out that the account had been blacklisted by the platform.
The final overall situation is that I listened to so much “reliable news” and managed to make my capital shrink by ten percent after rushing out of the stock market. My own experience is a very typical information cascade. The first few pundits who gave the information did have their own decisions, followed by people who had some basic knowledge to buy and gain, and their decisions led directly to my choice. Throughout this process, I didn’t even try to think and analyze whether their decisions were right or not, because I trusted the choice of most people, especially the ones with authorities. After learning about the information cascade, I got a better understanding of what I encountered in the financial market.
Link Referred:
https://www.investopedia.com/articles/investing/052715/guide-understanding-information-cascades.asp