Financial Market Herd Behavior in Response to Obfuscation
With the increasingly information-driven speculative financial market in the 21st century, the underinformed and herd behaviors described in this Reuters article are quite common. Following the efforts by the US to rein in inflation through hawkish monetary policy, financial markets tumbled across the board. Upon softening inflation figures, the markets rebounded in just as dramatic a fashion, only to again correct following an obfuscating statement by the Fed. As the article notes, the saga is a testament to how investment strategies can be anchored around ‘misunderstood concepts’, and subsequently fuel ‘herd-like trading’. The article references a statement by Meir Statman, an expert on behavioral finance, where he identifies the shorthand nature of parsing large quantities of high-frequency information causes people to ‘look for help wherever they can get it’. I believe this links strongly to the information cascades concept covered in class.
In class, we learned information cascades are a rational phenomenon in which one makes a decision as a function of personal knowledge and prior persons’ decisions. In financial markets, this is akin to the decision of acting bullish or bearish with various financial instruments. In unprecedented situations, as we are seeing with these rate hikes, the personal knowledge of any given individual is given less weightage than that of the greatest bank of knowledge – the market’s motion itself. Upon the breaking of rate hike news, the first movers in the market would have been informed by their market strategy – as alluded to in the article by the use of ‘intelligent’ and automated trading techniques. However, the influence of these on the market would have significantly informed the strategy of all that follow. This herd behavior is as limited new information will continue to get added to the cascade, with individuals imitating their predecessors on the premise that the masses can’t be wrong. On the largest scale, we have seen this exact behavior lead to hugely erroneous collective behavior, with the stock market in particular experiencing wild rallies and corrections. This erroneous behavior is as over time, personal knowledge of investors regarding a given company or instrument will be overriden by sharp movements in the market in the opposite direction as it does not seem rational to claim only oneself is right while everyone else is wrong. The fragility of information cascades is embodied in this behavior too, as a sudden report or action in the real world that clairifies the charactersitics of a company or instrument could suddenly trigger a complete inversion of the direction propogated by the information cascade.
Link: https://www.reuters.com/markets/currencies/fed-pivot-draws-closer-word-has-had-its-day-2022-11-11/