Jumping On The Bandwagon Effect

American Venture Magazine has an interesting article (from a bit ago) on the effect of “Bandwagons” (in other words information cascades) on the world of venture capitalism. Venture capitalist investments tend to not be taken lightly as investing in this sense is a very high-risk business. A great deal of research and analysis goes into finding the next big investment, however investors can’t wait forever. VC is all about grabbing at the initial economic surplus before it is all gone, and so in order to be effective investors must move fast. This fast-paced nature leaves the investing world open to attack, so to speak, by what are essentially financial information cascades.

For instance, say a small technology company Stuff Co. has a stock price of $20 at the beginning of the day. They announce that they are preparing to release a new product that will revolutionize the Stuff industry. Investor X, a bigwig in the VC world, (unknowningly) makes a mistake and decides to pull his investment from the company as he was misinformed of the announcement by the company by one of his associates (who will later be fired). The next few smaller investors see both the announcement and X’s action and decide to pull out as well, as they assume X must know something they don’t since X is such a big name. Now more investors see that despite this huge announcement a number of large investments have been pulled and they decide similarly to withdraw so as not to be left out. Stuff Co., who had assumed their stock would skyrocket with the announcement of the revolutionary technology, is shocked to find out that their stock is now worth a total of $1 a share! Will this extreme downfall last?

There are two posibilities for the future of this once great company. In possibility 1, A new investor could come along, realize the overwhelming benefit of the new product, and decide to invest oodles of money. Subsequent investors would see this action, which supports the initial announcement, and decide to invest as well, thereby reversing the cascade. Soon after, Stuff Co.’s stock has risen again (though whether or not it meets or exceeds the intial stock price depends on the situation). In possibility 2, before the market has a chance to begin to balance out, Stuff Co. goes under due to the tremendous, unexpected loss of capital. In this example, let’s assume that the later takes place. Now this new, revolutionary technology may be lost to society forever.

These kind of cascades often result in “bumps” in the overall value of a stock. The stock will briefly shift a large amount (either positive or negative depending on the initial actions), then quickly move in the other direction, often ending up where it started. Because of this, it’s quite possible for big events, such as the announcement of a new technology or product, may be met with decidedly less-than-expected results. A new product announcment could even potentially tank what could be a great thing. It’s a pretty scary thought that the future of many potential innovations may never see the light of day due to a very small number of misguided mistakes, and the instinctive human need to follow the crowd.