Informational cascade

What Is Informational Cascade?

An informational cascade occurs in behavioral economics when individuals make sequential decision-making based primarily on the observed actions of those who made decisions before them, rather than on their own private information. This phenomenon, which falls under the broader category of behavioral finance, can lead to situations where a collective action emerges quickly, even if that action contradicts the private knowledge or signals of many participants. The core idea is that observing others' choices conveys public information, which can overwhelm an individual's private assessment, causing them to disregard their own signal and simply follow the observed trend.

History and Origin

The concept of informational cascades was formally introduced and explored in detail by Sushil Bikhchandani, David Hirshleifer, and Ivo Welch in their seminal 1992 paper, "A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades." Their research provided a theoretical framework to explain why localized conformity of behavior and the fragility of mass behaviors occur. The paper posits that an informational cascade happens when it becomes optimal for an individual to disregard their own private information and instead follow the actions of those who preceded them, based on the assumption that earlier actors possessed superior or more accurate information.⁷ This work highlighted how collective decisions could be highly susceptible to minor initial perturbations and public observations, even if those observations were based on limited or incorrect data.

Key Takeaways

• An informational cascade describes sequential decision-making where individuals imitate prior actions, often disregarding their own private information.
• Cascades can lead to collective actions based on minimal initial information, making them fragile and susceptible to rapid shifts.
• The phenomenon is significant in financial markets, contributing to sudden shifts in market sentiment and price movements.
• Understanding informational cascades helps explain instances of widespread adoption or rejection of assets that may not align with fundamental values.

Interpreting the Informational Cascade

An informational cascade illustrates how collective actions can diverge from rational outcomes, even when individual actors are rational. The interpretation hinges on the idea that public information, derived from observing previous actions, can become so influential that it overrides diverse private information signals. When a cascade forms, subsequent individuals contribute little new information to the collective decision because they are primarily mimicking others. This can lead to a situation where a large number of people participate in a particular action (e.g., buying or selling an asset) without sufficient grounding in underlying fundamentals. The fragility of informational cascades means they can be easily reversed if new, credible public information emerges that contradicts the current trend.

Hypothetical Example

Consider a new technology company, "FutureTech," that has just gone public. Five potential institutional investors—Alpha, Beta, Gamma, Delta, and Epsilon—are considering investing. Each has conducted their own initial due diligence and possesses some private information about FutureTech's long-term prospects.

• Step 1: Alpha, based on its strong private signal, decides to invest heavily in FutureTech.
• Step 2: Beta observes Alpha's substantial investment. Beta's private signal is mixed, but seeing Alpha's confidence, Beta decides to also invest, placing more weight on Alpha's apparent positive assessment than its own ambiguous signal.
• Step 3: Gamma observes both Alpha and Beta investing. Gamma's private signal is negative, suggesting FutureTech is overvalued. However, seeing two prior investors commit, Gamma concludes that Alpha and Beta must have superior information. Ignoring its negative private signal, Gamma also decides to invest. At this point, an informational cascade has begun.
• Step 4: Delta and Epsilon, upon observing the actions of Alpha, Beta, and Gamma, also decide to invest. Their own private signals, whether positive, mixed, or negative, are overshadowed by the public signal created by the preceding three investors.

In this scenario, Gamma, Delta, and Epsilon made investment decisions contrary to, or without sufficient regard for, their private information, simply by observing and imitating the actions of those before them. This collective action could inflate FutureTech's stock price, creating an asset bubble not fully supported by all available information.

Practical Applications

Informational cascades manifest in various aspects of financial markets and economic behavior. They can help explain rapid shifts in stock prices, the formation of asset bubbles or market crashes, and sudden movements in currency or commodity markets. For instance, a small group of influential investors making a particular trade can trigger a cascade, leading others to follow suit without independent analysis. This can be particularly evident in markets characterized by information asymmetry or high uncertainty.

In the corporate bond market, institutional investors may exhibit "herding" behavior, influencing prices. Research has shown that institutional herding is prevalent in the corporate bond market, with sell herding sometimes leading to transitory but significant price distortions, especially for riskier bonds. Sim⁶ilarly, in real estate, a few initial purchases in a newly developing area, even if based on minimal private information, can spur a cascade of further investments, driving up property values. Regulators and policymakers also consider informational cascades when designing rules for market transparency and disclosure, recognizing that the rapid dissemination of certain information, or lack thereof, can exacerbate cascading behavior. The actions and communications of central banks, such as the European Central Bank (ECB), can also significantly influence financial markets, potentially initiating or countering cascades through their public statements and policy signals.

##⁵ Limitations and Criticisms

While informational cascades offer a powerful explanation for certain collective behaviors, they have limitations. A key criticism is the difficulty in empirically distinguishing a true informational cascade—where individuals ignore their private information—from other forms of correlated behavior, such as simultaneous reactions to shared public information or incentives. In financial markets, for example, many investors might take similar actions because they are all reacting rationally to the same economic news or market data, a phenomenon sometimes referred to as "spurious herding."

Furthe⁴rmore, the model typically assumes individuals make sequential decisions and can observe all previous actions. In complex, liquid markets, this perfect observability is often absent, and decisions are made simultaneously or based on incomplete information about others' exact strategies. Critics also point out that while a cascade can explain why undesirable outcomes persist, it doesn't always account for how a cascade begins or why it might reverse. The concept also assumes a degree of irrational exuberance or at least a discounting of personal insight, which may not always hold true. The "behavior of crowds" in financial markets, which can lead to significant price gyrations, often appears to defy the "wisdom of crowds" where aggregated individual estimates are more accurate than any single one.

Inf³ormational Cascade vs. Herd Behavior

While often used interchangeably, "informational cascade" and "herd behavior" describe distinct yet related phenomena in investor psychology. An informational cascade is a specific mechanism that can lead to herd behavior. In an informational cascade, individuals rationally decide to ignore their own private signals because the public information conveyed by the actions of predecessors is deemed more reliable or compelling. The key here is the information component: observing others' choices provides a proxy for their private information, leading subsequent individuals to follow suit.

Herd behavior, on the other hand, is a broader term that refers to the general tendency of individuals to align their actions with those of a larger group. While informational cascades are a common cause, herding can also stem from other factors, such as reputational concerns (e.g., fund managers fearing being seen as contrarian if their private information leads to poor performance), direct payoff externalities (benefits from aligning with the crowd regardless of information), or simply a desire for social conformity. For ins²tance, institutional herding among investment funds can occur when managers mimic each other's investment decisions, partly due to reputational incentives, even if it leads to socially inefficient capital allocation. Therefo¹re, while all informational cascades result in a form of herding, not all instances of herd behavior are necessarily driven by informational cascades.

FAQs

Why do people participate in an informational cascade?

People participate in an informational cascade because they rationally believe that the accumulated actions of previous individuals convey valuable information. Even if their own private information suggests a different course of action, the public signal from others' choices can be strong enough to make them disregard their own initial assessment. This creates a logical incentive to follow the crowd.

How does an informational cascade affect financial markets?

In financial markets, informational cascades can lead to rapid price movements that are not always tied to fundamental values. They can contribute to the quick adoption or abandonment of certain investments, sometimes creating asset bubbles or sudden market crashes as investors follow initial trends rather than conducting independent analysis.

Can an informational cascade be broken?

Yes, informational cascades are often fragile and can be broken by the arrival of new, credible public information that contradicts the current trend. A strong dissenting voice, a surprising news event, or a change in underlying conditions can provide enough new data to shift the beliefs and actions of subsequent individuals, thus reversing the cascade.

What is the role of individual analysis in avoiding cascades?

Individual analysis and thorough due diligence are crucial for investors to avoid being swept up in an informational cascade. By relying on their own research and independent decision-making rather than solely observing others' actions, investors can make choices based on a more comprehensive understanding of an asset's true value, contributing to more robust portfolio construction.