Information Cascades and the Financial Market
An information cascade occurs when a person’s decision is made solely based on information about decisions made by those before them. It is the idea that if many people are choosing one thing, it must be better.
For example, person A goes to a new city. He hasn’t eaten and is deciding between two different restaurants A and B. Both restaurants A and B have a similar aesthetic, menu, and price range however A has a small crowd while B is empty. Person A is likely to go to restaurant A because there are more people before him that chose restaurant A over restaurant B. Even if B had slightly better aesthetics, or better prices, person A is more likely to go to restaurant A.
A more extreme side of information cascades is called herding, where individuals imitate other based on the idea that if a large number of people make the same choice, it has to be the better choice.
Information cascades are not just used in simple choices like where to eat but can also be seen in the financial markets. For example, if an average person sees that if an expert chooses a stock, they are likely to imitate the expert’s stock because they think that the expert has more knowledge and more information. They will likely put aside their own opinions and thoughts and follow the expert. Another example is that one neighbor overhears another neighbor talking about his stock picks. That neighbor then also chooses the same stock. From this point on, other neighbors will hear both of the first two neighbors and will likely choose the same stocks and assume they are good because more than one other neighbor chose it.
Hearing about information cascades in the financial markets is interesting because it is a location where there is much more at risk. Unlike more common examples such as deciding on a restaurant, decisions in these markets have to do with money, and therefore are much more important. However, the fact that these decisions as well are impacted by cascades makes me both worry for those people and want to study so I can back my own decisions. In the case that the original decisions in the cascade weren’t reliable, many people may have been negatively affected financially. There will possibly not be any immediate problems but in the long run, bigger financial harm may result. Yes, many times it is helpful to take into consideration the decisions of others, however it is important to source that information and make sure your own thoughts and opinions are in play when making financial decisions.