How Information Cascades Pushed Bitcoin to the Top
Information cascades- basing your decisions on the observed behaviors of other individuals while ignoring your personal information- is a very common and relevant topic when discussing the stock market. In today’s stock market, no one individual has a competitive advantage over other individuals due to all information being public and easily accessible (if you are acting on none public information it is considered insider trading and results in federal punishment). This transparency in information sharing can cause information cascades and herding, leading to irregular and irrational market valuations. Often, stocks rise well beyond their actual intrinsic value because of the herd mentality of the market. This is most prevalent when stocks rise or fall rapidly, causing investors to follow the signal from the behavior of others and make irrational decisions. This causes the price of the stock to continue to rise or fall even further, akin to a self-fulfilling prophecy. These signals are classified as “positive” or “negative” signals and have led to what is called momentum trading, where some investors attempt to exploit sudden swings in the market to their advantage[1]. One individual might not be able to alter stock prices; however, a herd of irrational investors certainly can heavily influence the price of a stock.
A clear example of the type of ‘herd’ mentality is displayed with the recent development of the cryptocurrency market. Bitcoin is a prime example of how information cascades and herding can lead to over valuation of stock prices. Bitcoin’s price increased from $900/bitcoin to over $20,000/bitcoin in under 12 months. Bitcoin was the first successful cryptocurrency[2]. With the combination of the cryptocurrency market having no concrete valuation, the positive feedback and self-fulfilling prophecy caused by investors- who had very little information on bitcoin or cryptocurrency market, to irrationally buy into the trend. Bitcoin, along with the other cryptocurrencies- the stock became very volatile due to so many investors being uninformed and solely acting on the behavior signals of others. At the beginning of 2018, there were thousands of established cryptocurrencies, many of who are arguably much better than bitcoin, but people were focusing heavily on bitcoin because of the information cascade caused from the initial momentum of the stock inflation. The graph below depicts the linear relationship of bitcoin’s surge in price and google hits, demonstrating the ripple effect of the information cascade and the resulting price influx from the herding. An important aspect to consider when looking at the cryptocurrencies is the “whales” that carry much weight on the stock prices. When looking at people that have this much power, it is commonly referred to as reputation-based herding, due to the skewed weight the signals of these individuals offer to the market. For instance, Mike Novogratz- one, if not the main, advocate for bitcoin- stated in an interview that he expected bitcoin to reach a price of $20,000/bitcoin when the price was at a mere $5,800/bitcoin[3]. The same day the price of bitcoin jumped to over $7,000, demonstrating how much power certain individual’s signals can have on the behaviors of other investors.
The important takeaway being that although the stock market is theoretically a competitive and efficient market due to all information being accessible by anyone, investors still make irrational decisions by basing their evidence of the behaviors of others and ignoring or not seeking their personal information.
