Using Decision Cascades to Explain Price Movements in the Stock Market

Intro:

During the course, we learned about how people have the tendency to let other peoples decisions affect their own and how this can create decision cascades among certain groups. One place where this can be seen is in the equity markets and, as a casual investor, I’ll dig deeper into the relationship between decision cascades among investors and price of equities in this blog.

Analysis:

The price of a stock, like many other goods, is influenced by supply and demand. We are all aware about how company performance can influence demand (investing in a company is more appealing if they provide good profits, growth, and guidance) but arguably a bigger influence on demand is the tendency of investors – experienced ones included – to follow the herd and copy the trades of other investors.

Consider this scenario, an investor sees many other investors buy a certain stock. They know that this will increase the price of the stock and they begin to do the same. This in turn influences investors watching them to do the exact same for the same reasons. This creates a cascade in demand which causes the price of the equity to go up such as what happened during the meme stock craze (Figure A). Note that this effect can also work in the opposite direction as investors trying to avoid a drop in stock price can create a cascade where everyone sells, leading to a crash in price (Figure B).

Ultimately, these cascades don’t last forever, and we are eventually  left with two coexisting communities of investors: those who own the equity, and those either don’t invest in the market or just won’t purchase the stock. This causes the price of the stock to stabilize in the meantime.

Example:

A good example of the effect of decision cascades on stock prices can be seen in Amazon’s stock movements

In March 2020, the US federal reserve announced that they’ll be lowering interest rates and injecting money to stimulate the economy during the pandemic. This made putting money into the stock market more attractive and soon a cascade began which drove up the price of many stocks including Amazon.

By late 2020, the cascade began to stop and price of Amazon shares began to stabilize.

At the beginning of 2022, the federal reserve announced that they would be taking measures to cool down the economy which made stocks, particularly those of tech companies, less attractive. This, combined with poor forward guidance from the company, lead to a cascade where investors began selling the stock which caused the price of the stock to drop.

Conclusion:

The monumental impact decision cascades have on the equity markets reveal how the human urge to follow the herd impacts the world we live in. It also reveals how the stock market may be one giant coordination game and that the key to successfully predicting the movement of stocks isn’t to focus on the behaviour of the companies but the behaviours of the investors.

Sources:

Google. (n.d.). Amazon.com, inc. (AMZN) stock price & news. Google Finance. Retrieved December 1, 2022, from https://www.google.com/finance/quote/AMZN:NASDAQ?sa=X&ved=2ahUKEwj2gKeHytv7AhV4i3IEHZTYBfkQ_AUoAXoECAIQAw

Nicenko, A. (2022, November 8). Why is FTX token crashing? FTT plunges 80% wiping $2.5 billion from its market cap. Finbold. Retrieved December 1, 2022, from https://finbold.com/why-is-ftx-token-crashing-ftt-plunges-80-wiping-2-5-billion-from-its-market-cap/

Nguyen, J. (2021, January 28). Why is gamestop stock going wild right now? MarketPlace. Retrieved December 1, 2022, from https://www.marketplace.org/2021/01/27/why-is-gamestop-stock-going-wild-right-now/

Palmer, B. (2022, November 22). Understanding information cascades in financial markets. Investopedia. Retrieved December 1, 2022, from https://www.investopedia.com/articles/investing/052715/guide-understanding-information-cascades.asp#:~:text=Information%20cascades%20can%20be%20common,imitate%20the%20pundit’s%20stock%20picks.