Herding and Information Cascades in the Financial Market
Information cascades occur when people who are connected by a network influence the behavior of their counterparts; this is sometimes also defined as “herding.” Cascades occur in a specific progression: one after another, based on decisions or choices made by people “ahead” of the individual making a given decision. This is also viewed as, according to Networks, Crowds, and Markets: Reasoning About a Highly Connected World (David Easely and Jon Kleinberg), “imitating the behavior of others, but it is not mindless imitation. Rather, it is the result of drawing rational inferences from limited information” (484). As social groups increase, so too do the “social forces of conformity,” as when one sees a large group of people doing something — as seen in the looking at the sky experiment touched on in Chapter 16 of the text — they are more likely to imitate that behavior than they otherwise would be with a smaller group.
Among areas of application of information cascades is the financial market. For example, a person looking to invest in the stock market could ask a financial advisor for help, and subsequently use their advice and the information given to invest. Following this, the person looking to invest could share the information they learned from the financial advisor with others interested in investing, and invest in the same stocks. The next potential investor would follow this information as well, seeing as two people before had done the same. This “cascade” would continue from person to person, and although the first person was specifically advised, the other participants had limited knowledge on the source. All of this being said, if the financial advisor did not give good advice, all of these subjects would see negative outcomes.
Another example of the way in which information cascades and herding manifests itself in the stock market is when traders and investors are put in “vulnerable positions” and therefore more inclined to follow the herd, especially when there are uncertainties. In the stock market, there are three forms of herding. The first is information-based herding, in which “everyone reacts the same way to announced information,” meaning that the decisions made by traders are dependent on the decisions made by traders before them. The second is reputation-based herding, which occurs when a “respected investor or major trading house take[s] a specific trading stance: because of the respect associated with this investor, people are inclined to follow exactly what they are doing. The third type is compensation based herding, which happens when “conditions prompt large institutional money managers to take profits, generally to protect fund earning before year-end reporting.” This causes those paying attention to those profits to react quickly and based off the decisions of one another.
All of this being said, information cascades are very apparent in the financial markets and industry, as those engaged in the market constantly make decisions based on one another.
Works Cited:
https://repository.upenn.edu/cgi/viewcontent.cgi?article=1324&context=marketing_papers
https://finance.zacks.com/herd-behavior-stock-market-9833.html
https://www.cs.cornell.edu/home/kleinber/networks-book/networks-book-ch16.pdf