Understanding Information Cascades in Financial Markets

An information cascade occurs when a person makes a decision based solely on the decisions of other people, while ignoring their own personal knowledge to the contrary. It's a theory used in the field of behavioral economics and has important implications for financial markets. Recognizing and avoiding this behavior can help people make better financial decisions.

How an Information Cascade Works

Information cascades usually develop when there's no direct verbal communication between individuals. For this example, let's assume that there are four individuals, M, N, O, and P. They're faced with two choices: accept or reject. Each person sequentially makes their choice.

M is the first decision-maker, and as such will make a decision based on personal knowledge. Let’s suppose M accepts.

N is the second decision-maker and has the public knowledge that M made a decision to accept. N may choose to either accept or reject based on both personal knowledge and public knowledge. N chooses to accept.

Now, let’s assume that O ignores personal knowledge that supports rejecting and accepts only because both N and M have already accepted. This forms an information cascade. O is essentially just imitating the others.

P observes the choices of M, N, and O and imitates them by making the same choice to accept.

Key Characteristics

Herd Behavior

After a point, very little new information is added to the cascade, and individuals just imitate others based on a belief that such a large number of people can't be wrong. This is referred to as herd behavior. This imitation can lead to erroneous behavior on a massive scale. Examples are market bubbles and collapses.

Fragility

Information cascades are generally very brittle by nature, as individuals may be reacting only to hearsay and public observation. Any new public information or a more precise information source can change the actions, as well as the direction of the cascade.

Disappearance of External Information

When people make decisions based on the actions of others, they're not adding new information to the public’s knowledge base.

Examples in Financial Markets

Information cascades can be common in financial markets. For example, an average person might think that a financial pundit has more knowledge and information than they do. Because of that, they imitate the pundit’s stock picks.

Maybe that person's neighbor observes them boasting about their stock picks, and so the neighbor also picks the same stocks. Another neighbor notices that both people chose the same stocks and assumes that those stocks must be good picks, simply because more than one person has picked them.

The information cascade has begun, and all of the participants have very little information to back up their decision-making.

If the initial source in an information cascade isn't a reliable and knowledgeable person, or if conditions change, then the cascade may cause great financial harm in the long run.