The "If they do it, they must know something I don't know"
syndrome.
Definition (in general) :
In general, an information cascade is a collective behavioral bias by which a superficial
(and often emotional) interpretation (availability cascade) of a minor event is spread
and amplified.
Definition (in a market)
A market-type information cascade materializes in a
 snowballing / cumulative
price move.
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 It starts with an initial
 price change that players interpret as
a signal that other players have relevant information.
It persists in a series (cascade) of self-reinforcing information / self-feeding
behavior.
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 How does the market start the
 flow?
Do those guys really know something I don't know?
Or is it just what the water-tasting / cascade-rafting players believe?
An information cascade can start from a tiny
 buying or selling surge by some traders,
for good or bad reasons.
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They are imitated by other players who suppose
that the first ones are better informed than them.
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This launches a repetitive move in which all players
 imitate one another
instead of taking into account their own private information.
This gives a series (cascade) of
 self-reinforcing
information / self-feeding behavior
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This phenomenon has some similarities with (see those words):
The "beauty contest", but without the divinatory element.
And it might be called ...ugliness contest when it sends price spiraling downwards,
"Herding" (but without the emotional content).
Viral communication, rumor, buzz, meme and other social epidemics and self-replicating phenomena found in social communication.
Short term and long term market cascades
How fast can the cascade get dry again?
A continuous trickle or avalanche (depending on its strength) of buying or selling
irrupts
sometimes in financial markets.
It sustains an upward or downward, temporary or persistent,
price trend.
We have here a serial "positive feedback loops" (see the word "feedback"), in which
events get farther and farther from the mean, leading to a vicious (or sometimes virtuous)
spiral.
Actually, there are:
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Many
 short term cascades, which usually abort soon
(often the day they started),
But also some
medium / long term ones that
can reach extreme price lows and highs. Full
 overflow!
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This happens when investor's emotions enter the game and reinforce what was at
the
beginning only a feeble cognitive phenomenon (see below the section about persistent
cascades).
Sometimes, if the move becomes quite strong, it can even influence fundamentals
in a self-predicting way (see reflexivity, self fulfilling prophecy).
How is an information cascade triggered in financial markets
and how does it evolve into a spiral?
An ear on the rail, in case an incoming financial train splash a vapor cascade
At its start, a financial information cascade can be triggered by a minor
information,
which breaks through the surrounding "noise" and comes either from outside (exogenous)
or from inside
(endogenous) the market
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1) Cascade activated by (positive or negative)
 "exogenous" information
(= coming from the economic sphere)
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After this preliminary
 signal, market prices start moving, maybe
excessively.
The real cascade starts when this price move is taken as an endogenous
signal(= one coming from the financial sphere, in this case the asset market).
This convergence between exogenous and endogenous signals might start the
spiral - even in the lack of new confirmation from the economic sphere.
By the way, the economy also can have its own self reinforcing phenomena.
They lead to economic development or decline in the long term, or to cyclical
expansion or depression in shorter periods.
Inflation spirals are another example, when people buy and hoard goods
by fear of inflation, contributing themselves to the price rise.
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2) Cascade proceeding directly from an
 "endogenous" info
(from the financial market itself, a noticeable price move usually).
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In this case:
1) The first information is a conspicuous market price rise or fall, in the
absence
of any visible economic event than would explain it.
2) Some players take it as a
 signal that some other traders are buying or
selling because "they must know something that I don't know",
This is typical "noise trading" (see that phrase).
Somebody raises a little its voice, everybody does.
2b) Thus, they join the party and buy or sell in their turn.
Those actions reinforce the rise or fall, they add a second wave to it,
3) This new move creates the feeling among investors that the trend is
confirmed,
It attracts even more people, who think there must be a good reason for it,
and who tend to believe and spread the associated chatter, gossip and noise.
Those additional players start a third wave of rises or falls.
4) - 5) - X) Another
wave of people sees that and act on
their turn, and things are cascading on and on.
Thus, even a lack of initial information by the first people who started
the trend can
 solidify into an information for the next ones who
saw them acting.
It shows that the trend can start out of nothing, when a pure noise
is taken as a signal (see noise, signal).
Technical analysis might play a part, when traders wait for a rise or fall,
as a signal that the trend is reverting, before they start to buy
or sell.
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Are information cascades rational?
Tactical followers sharing the shower.
In an information cascade, people decide consciously not to use their private information
and to act as "followers".
They deliberately consider the information that other players seems to know as more
relevant
than what they know by themselves.
They feel under-informed on fundamental facts. Thus they have
more trust in  market price information, even if it is just
a noise or a slight adaptive market move.
Cascades vs. herding. And how persistent are they?
Flowing calculators? Or flowing cattle?
Cascades are sometimes called "rational herding". Is that definition justified ?
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Rational? |
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Irrational? |
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There is some rationality, cool
 calculation and consciousness
in information cascades, even if it
canbe called a perverse
rationality.
Some even talk about rational
bubbles, rational crashes, rational
herding (hmm, why not rational
...irrationality?
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But when the momentum reaches
extremes, emotions
such as greed, fear, pride, envy
come into play and paralyze
thinking.
A typical emotional herding (see
that word).
To call cascades "rational herding"
can be justified in a first phase,
but no more once emotions take
control.
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Actually, without that
 emotional support,
the cascade does not reach the herding critical
threshold (see percolation) and aborts rapidly. |
Information cascade that are not fed by emotion are fragile, as dispassionate people soon
start to
 check if there are some fundamental realities behind it, or if in fact the king is
naked. That is
why,
People might obtain gains in that specific category of "trend-following",
based on the belief of hidden / private information.
This is one of the notions that is behind technical analysis.
But they might lose more than what they gained when the cascade music stops
and price trends start
 to revert or to go astray.
Examples
Look at that, some cascades flow upwards!
Here are examples of two opposite long term cascades,
a continuous stock market rise and a continuous stock market fall:
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 Bullish cascade
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In a first step, a stock (or other asset) price rise
happens at random, without any
relevant exogenous event (an effect of noise traders activity for example).
This rise is seen by some investors as a positive information.
They act on this belief. This initiates a new price rise, which in its turn attracts
the
attention of other investors.
The steady arrival, every time there is a new rise, of new buyers who think that
those who bought just before them must know something, fosters progressively a
bullish trend or even a
 bubble.
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 Bearish cascade
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Cascades take place also in bearish trends and in
crashes.
Some first investors get weary or cautious, even if no relevant new event takes place
to cause it.
Under such an impression, they leave the game. They are then followed by others.
This is how
 Crashes usually start out of the blue, without new exogenous
economic events.
This does not mean there are no reasons at all, as overpricing is usually the
real
cause.
But the precise moment when the market will act on that reality is rather
unpredictable, there are often no discernible early warnings that the party
is over.
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