Information Cascades in the Stock Market
In the financial world, herding behavior refers to the phenomenon by which investors will base their investment decisions on the decisions of other investors. However, in general standard stock trades in the market are not the result of herding behavior, in that individuals will buy or sell a given stock given the success they anticipate of that particular stock. Where herding behavior arises in the stock market is in the uncertainties surrounding the financial market. This articles defines three main types of herding in the markets. Information-based herding, when a large group of investors, in this case, react similarly to announced information. Reputation-based herding, when investors base decisions off of the decisions of a notorious or very well-respected investor. Lastly, compensation-based herding, when a financial institution controls a large quantity of financial assets, for securing profits, sells a large amount of stock in a sector that is commonly traded in, resulting in reactions from a large number of other investors. Usually, herding behavior in the financial markets is sparked when investors take note of unusual trading activity, trade imbalance. Upon recognition of this trade imbalance, investors will come to believe that those who were part of the trade imbalance know something they do not, so they follow the unusual activity. In a scenario where the price a stock sold for is abnormally high investors will fear that there is some reason that the price of the stock will go down, resulting in the selling of those investors stocks to avoid losing money. On the other hand if an unusually large quantity of a stock is bought, investors would will buy this stock because they believe that those who initially bought the stock had some reason to believe the price would go up.
The herding behavior described in this article can be largely related to information cascades. As we have discussed information cascades occur when the information provided by previous decision-makers’ decisions take precedence over a decision makers private information. In the case of this article the investors private information is their own evaluation of a company or a stock. Take a scenario where an individual investors analysis of a company or stock leads them to believe that a current product of theirs will decrease in popularity. This would lead them to either not buy, or not sell stock in this company. An information cascade would occur when an investor sees that a previous investor has decided to sell a stock. The investor does not have access to the previous investors private information, only access to his own private information, but decides that the previous investors’ private information supported his ultimate decision of him selling the stock, and these signals to sell are more powerful than the investor’s own private information, so the investor decides to sell as well. Now, the next investors have even more signals to sell, and will also sell. This results in a cascade that ultimately leads to the value of the stock decreasing significantly. Then on the contrary, if the initial investors had decided to buy the value of the stock would then increase drastically. This shows us that large changes in stock prices can result from a small amount of what could potentially be non-credible or inaccurate initial-decision making analysis. In the case of the stock market these cascades occur rapidly, which makes them even more likely to occur. This stems mainly from investors lack of time to do research or analysis allowing them to gain more private information. This is why the tendencies of information to occur in stock markets is the basis of stock promoters. A company does not need to convince a ton of investors that their companies stock will be successful, but rather a small group of investors so as to initiate the informations cascade.
What makes the stock markets so interesting is herding behavior’s prevalence to the markets, which makes the possibility for information cascades. In the stock market the value of a stock is based largely on investors willingness to either buy or sell a stock, at least in the short term. If a mass amount of people decide to sell a stock the value of that stock will go down drastically. The investors private information plays a partial role in the price of a stock, but this shows that news and information is power in the life of a trader and that your reputation all account for how much bearing you as an individual take on the stock market.
Links:
https://finance.zacks.com/herd-behavior-stock-market-9833.html
