http://else.econ.ucl.ac.uk/newweb/research/blurb1.php

The field of behavioral finance gleans much from the idea of information cascades.  In particular, the herding phenomenon has caught the attention of Dr. Antonio Guarino and Marco Cipriani.  In the case of trading stocks, herd behavior is the act of disregarding a trader’s own private information in favor of previous traders’ actions. The results of their experiments are very interesting.  For instance, one of their conclusions was that herd behavior is limited when traders trade just using information.  However this only works in a perfect market because herding almost always occurs once transactions costs are introduced.  More interestingly, this research has implications in the study of financial contagions where herding moves between markets.

Guarino introduced “social learning” as the rationale behind the herding behavior of traders.  Much like the simple model introduced in class, traders look to learn from the actions of traders who precede them.  The first few traders may trade based on the signals their private information gave them or perhaps for liquidity or other non-informational reasons.  For example a trader may have information that leads him to expect a firm to miss its earnings estimate.  He would be inclined to sell or short that stock.  A second trader could arrive at the same conclusion based on his own information and sell as well.  A third trader’s private information is now rendered useless.  His signal is no longer a deciding factor as it will be eclipsed by inferred signals of the first two traders’ actions.  Of course the financial markets with all the volume and traders involved can seriously be modeled in this fashion.  However, that gives an idea of how it could work.  Guarino states that informational reasons to trade erode in importance as non-informational reasons dominate and generates herd behavior.

This has important implications in terms of stock frauds.  Falsely propping a stock up and sending false signals can cause an information cascade to occur and cause a bubble to develop.  For example, a wealthy investor can afford to buy enough shares of a stock over a short period time of to create the illusion of high demand.  It is even possible, especially in emerging markets, to disguise one as several different entities thus creating the illusion that several traders have bought the stock.  In this fashion, the investor may create an information cascade that causes the price of the stock to skyrocket.  Of course, that investor will jettison at the peak of the bubble leaving the rest of the cows to jump off a cliff.  Although the risks of such fraud is relatively low in the United States, investors should still be wary and keep the concept of herding and information cascades in the back of their minds.