According to a paper by Len Skerratt in 2000, there is substantial evidence that financial markets do not react to information exactly as suggest by the efficient market hypothesis as argued by many. How can this be? One of the main explanations contribute the discrepancies to exogenous imperfections such as transaction costs. However, Skerratt focuses on behavioral causes and how agents actually process information rather than on imperfections. The subject of the paper is on how agents respond not only to their own private information, but also to the information which they infer other agents have. As discussed in class, these inferences are made on the basis of the actions which other agents are seen to take.

The idea behind market efficiency is that agents have private information which influences trading. The actions from the information is immediately reflected in the price (good news will push prices up). One of the main points of the paper is that when investors make sequential decisions, they will tend to ignore their own information and be guided by the actions of others. This is an inescapable spiral where subsequent investors only observe the uninformed choices of previous investors, which then ultimately reinforce the original choice (regardless of right or wrong). The paper continues on to quantify this theory and the origins of a cascade.

Skerratt draws several conclusions from his theory: The more informed will tend to go first since the less informed will wait to see what others are doing, thus ultimately most decision will be correct; but! the less informed may also go first, this happens because the more informed will wait until the market is really out of wack and strike later with their private information. Skerratt concludes that cascading in financial markets with respect to accounting information makes the most sense. It is the most public and strongest information available to the investor.

For more on Skerratt’s theories refer to:

http://cascades.behaviouralfinance.net/Sker00.pdf