Behavioral finance FAQ / Glossary (Cascade)

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	Dates of related message(s) in the Behavioral-Finance group (*): Year/month, d: developed/ discussed, i: incidental
(Information / informational) Cascade, cascading	00/7i - 01/4i,9i,10i,12i - 02/1i,8i,9i - 03/6i,11i,12i - 04/10i - 06/2i,3i + see (rational) expectations, rational bubbles, crashes, trend, signal, noise, reflexivity, beauty contest + bfdef2
The "If they do it, they must know something I don't know" syndrome. Definition: an information cascade in a market is a  snowballing / cumulative price move. It it is started by an initial price move that players interpret as a signal that other players have relevant information. It persists in a series (cascade) of self-reinforcing information / self-feeding behavior. How does it start flowing? Do those guys really know something I don't know? Or is it just what the water-tasting / cascade-rafting players believe? An information cascade starts from a tiny buying or selling surge by some traders, for good or bad reasons. They are imitated by other players who suppose that the first ones had better information than them. This launches a move in which all players imitate one another instead of taking into account their own private information. This gives a series (cascade) of self-reinforcing information / self-feeding behavior. This phenomenon has some similarities with (see those words): The "beauty contest", but without the divinatory element. And it might be called ...ugliness contest when it sends price spiraling downwards, "Herding" (but without the emotional content). Short term and long term market cascades How fast can the cascade get dry again? This continuous trickle or avalanche (depending on its strength) of buying or selling irrupts sometimes in financial markets. It sustains an upward or downward, temporary or persistent, price trend. We have here a serial "positive feedback loops" (see the word "feedback"), in which events get farther and farther from the mean, leading to a vicious (or sometimes virtuous) spiral. Actually, there are: Many short term cascades, which usually abort soon (often the same day they started), But also some medium / long term cascades that can reach extreme price lows and highs. This happens when emotions arise and reinforce what was only at the beginning a feeble cognitive phenomenon (see below the section about persistent cascades). Sometimes, if the move becomes quite strong, it can even influence fundamentals in a self-predicting way (see reflexivity, self fulfilling prophecy). How is an information cascade triggered in financial markets and how does it evolve into a spiral? An ear on the rail, in case a financial train is coming. At its start, a financial information cascade can be triggered by a minor information, which just breaks through the surrounding "noise" and that is either. A positive or negative "exogenous" information (= one coming from the economic sphere). After this preliminary signal, market prices start moving, maybe excessively. The real cascade starts when this price move is taken as an endogenous signal (= one coming from the financial sphere, in this case the asset market). This convergence between exogenous and endogenous signals might start the spiral - even in the lack of new confirmation from the economic sphere. By the way, the economy also can have its own self reinforcing phenomena. They lead to economic development or decline in the long term, or to cyclical expansion or depression in shorter periods. Inflation spirals are another example, when people buy and hoard goods by fear of inflation, contributing themselves to the price rise. Or directly a pure "endogenous" info (from the financial market itself, a noticeable price move usually). In this case: 1) The first information is a conspicuous market price rise or fall, in the absence of any visible economic event than would explain it. 2) Some players take it as a signal that some other traders are buying or selling because "they must know something that I don't know", This is typical "noise trading" (see that phrase). Somebody raises a little its voice, everybody does. 2b) Thus, they join the party and buy or sell in their turn. Those actions reinforce the rise or fall, they add a second wave to it, 3) This new move creates the feeling among investors that the trend is confirmed, It attracts even more people, who think there must be a good reason for it, and tend to believe and spread the associated chatter, gossip and noise. Those additional players start a third wave of rises or falls. 4) - 5) - X) Another wave of people sees that and act on their turn, and things are cascading on and on. Thus, even a lack of initial information by the first people who started the trend can solidify into an information for the next ones who saw them acting. It shows that the trend can start out of nothing, when a pure noise is taken as a signal (see noise, signal). Technical analysis might play a part, when traders wait for a rise or fall, as a signal that the trend is reverting, before they start to buy or sell. Are information cascades rational? Tactical followers sharing the shower. In an information cascade, people decide consciously not to use their private information and to act as "followers". They deliberately consider more relevant the information that other players seems to have than what they know by themselves. They feel under-informed on fundamental facts, and thus they are more confident on  market price information, even if it is just a noise or a slight adaptive market move. Cascades vs. herding. And how persistent are they? Flowing calculators? Or flowing cattle? Cascades are sometimes called "rational herding". There is more rationality, cool calculation and consciousness in information cascades than in pure emotional herding, even if it can be called a perverse rationality. Some even talk about rational bubbles, rational crashes, rational herding (hmm, why not rational irrationality ? :-)) But when the momentum reaches extremes this interpretation is not fully convincing. Here, greed, fear, pride, envy or whatever other emotion obviously comes into play and paralyze thinking. Then we have typical emotional herding (see that word). To call cascades "rational herding" might be justified in a first phase, but no more once emotions take control. Without that emotional support the cascade aborts rapidly. Information cascade that are not fed by emotion are fragile, as people soon start to check if there are some fundamental reality behind. That is why, People might obtain gains in that specific category of "trend-following", based on the belief of hidden / private information. This is one of the notions that is behind technical analysis. But they might lose more than what they gained when the cascade music stops and price trends start to revert or to go astray . Examples Look at that, some cascades flow upwards! Here are examples of long term cascades going in two opposite directions, a market rise and a market fall:   Bullish cascade  In a first step, a stock price rise happens at random, without any relevant exogenous event (due to noise traders activity for example). This rise is seen by some investors as a positive information. They act on this belief and this initiates a new price rise, which in its turn attracts the attention of other investors. The steady arrival, every time there is a new rise, of new buyers who think that those who bought just before them must know something, fosters progressively a bullish trend or even a  bubble.   Bearish cascade . Cascades take place also in bearish trends and in crashes. Some first investors get weary or cautious, even if no relevant new event takes place to cause it. Under such impression, they leave the game. They are then followed by others. Crashes usually start out of the blue, without new exogenous economic events. This does not mean there are no reasons at all, as overpricing is the real cause. But the precise moment when the market will act on that reality is rather unpredictable, there are often no discernible early warnings that the party is over.

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