http://www.nytimes.com/2008/03/02/business/02view.html?pagewanted=print

Throughout the course, we have now studied game theory and auctions which all deal with situations in which people are faced with decisions to make. The article above is about information cascade and herding behavior which also deal with situations that people face when they have to make an important decision based on useful but incomplete information.

The article discusses people’s behavior from information cascade and herding behavior in the financial markets. For instance, people with investment decisions do not see any risk and only see the prospect of huge investment returns. Why is this the case? Well, some would say that people are irrational. However, I would like to believe that people are in their right minds when they are risking huge sums of money. In 1992, three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch reveal the answer to the people’s behavior. They explained that when people are faced with an important decision and have useful but incomplete information they tend to disregard their own judgment and follow others’ decisions.

When buyer A purchases stock thinking that it is a spectacular investment(even though it is not), Buyer B contemplates about whether to purchase that specific stock even when his own private information contradicts buyer A’s purchase. In this case, Buyer B is likely to disregard his own private information and proceed to purchase that stock that has low investment value in reality. With buyer A and B purchasing the stock, many other prospective buyers will also conclude that the stock is of great investment value. Then, the stock’s price skyrockets and it becomes a bubble that will burst in the same manner that it became a bubble. After couple of buyers sells the stock, the other shareholders become more and more pessimistic and also get rid of stock quickly, which generates a downward cascade.

This article shows that it is quite easy and simple to create cascading behaviors from people and that it is actually hard to detect whether something is a bubble or not. Even Alan Greenspan, as the article shows, was never sure whether the stock market was a bubble or not in the 1990’s. Experts like Greenspan are affected by the cascading behaviors of others. If the price of stock were constantly rising, why would any expert call it a bubble? Therefore, we must come to a conclusion that individuals are not rational as Bikhchandani-Hirshleifer-Welch proposed in their original paper.

Next time when you are facing a crucial financial decision, do me a favor to stop yourself and ask yourself one question. “Am I making the decision based on my own information and not based on what others are doing?”

Linke to the orignial paper by Bikhchandani-Hirshleifer-Welch

http://www.jstor.org/view/08953309/di014715/01p0058j/0