A fairly old article by Andrea Devenow and Ivo Welch written in 1996 still continues to accurately describe the financial world more than 10 years later.

Rational Herding in Financial Economics

The authors describe the success of the Herding and the Efficient Markets Hyporthesis (EMH) by discussing the stock market and the behavior of many investors. The stock market is a place that spawns numerous information cascades on a daily basis, yet these cascades are also extremely fragile. Investors can observe each other’s behavior and thus imitate what others are doing. (i.e. if a particular stock is selling really well, one might be more tempted to buy it). However, these investors also posses valuable private information that may persuade them to go against the cascade, and very often end it through the actions of just a few individuals.

As the authors of the article discuss, there are several strong reasons for imitating the actions of others:

“Payoff externalities models show that the payoffs to an agent adopting an action increases in the number of other agents adopting the same action (example: the convention of driving on the right side of the road).”

This is fairly obvious, since by adopting the actions of everyone else, one can minimize the chance of losing money because in a failing situation, everyone else would lose money as well, and from a relative perspective the investor would not lose anything. At the same time this creates an incentive to break the cascade, as obviously there is the potential for a lot of gain. Considering the same situation with everyone making the wrong choice; the one person who makes the right choice will end up with a much greater payoff. Another example of this can be demonstrated in the following situation:

“Payoff externalities may also drive the decisions of agents for which stocks they acquire information. Under certain circumstances, agents find it worthwhile to acquire further information only if other agents do. Agents thus herd on information acquisition (or lack thereof).”

Since acquiring additional information can be costly, one might choose not to do it if other agents choose not to. It can indicate that this extra information is unnecessary and would not bring a greater payoff. There is also the flipside of the issue where spending more on a little extra information can in fact result in a greater payoff. Thus, it is easy to see how information cascades spawn in the financial world, but at the same time are extremely fragile as there is always the potential of greater payoff through the choice of breaking the cascade.