Bubbles in the Stock Market: Dangers of Information Cascades
Investing in the stock market can be based on a few intentions. For individuals, this could be to secure, long-term growth or risky, quick profit turns. The rapid buying and selling for quick profits largely revolves around the preconceived expectations of the upcoming stock market behavior. Instances where large groups of individuals share the same beliefs of expected behavior often leads to rapid influx and market trades. For well-informed investors, this is common practice. For less-informed individuals, this can be dangerous. There is risk of mistakenly buying stocks at higher prices than the true value, especially in cases where the stock value is rapidly increasing. The behavior to ‘follow the herd’ and invest in these increasing stocks is analogous to the information cascades discussed in class. A large number of individuals investing in a specific stock has strong power to pull in other individuals to invest in the same stock. The danger arises when the stock becomes widely shared, or the product becomes widely available. Now share holders have paid significantly over the true value of the commodity, and are unable to generate a profit, let alone break even with the initial investment. The rapid spread of information among the general population, and the ease of investing in the stock market has increased.
Perhaps the most famous instance of this is the stock market crash in 1929. Large sums of people invested in public shares, with the expectation to turn a profit after a price increase in the shares. The increase in stock value appeared to follow a rapid increase. However, this really did not hold weight. The increase in price was not due to the increase in value of the product, but rather due to the increase in stock demands caused by the cascade of investments. Once the stock prices began to fall, people quickly tried to sell their worthless stocks, they were forced to do so at a much lower value than the original investments. The information cascade of investing created the artificial rise in stock value, which eventually led to the market crash, followed by the Great Depression.
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