Lesson 3.3 · 3 of 5 · Judgement and calibration
Herd behaviour and FOMO in investing: cascades and the dot-com bubble
Herding means buying or selling because others are doing it, not because of what you know. Following the crowd can even be rational, but your own information gets lost and bubbles can form. The Nasdaq fell by about 78% between March 2000 and October 2002 and only regained its peak in 2015.
Terms in this lesson
- Price momentum
- How much the stock has risen or fallen in recent months: the force of the move.
- Stock market index
- A basket of stocks that shows how a market is doing: S&P 500, DAX, BET.
- Maximum drawdown
- The largest fall in price from a peak to the lowest point after it.
What an information cascade is
Definition
What is an information cascade?
The point at which it pays to do what the people before you did, whatever you know yourself.
That is how the economists Sushil Bikhchandani, David Hirshleifer and Ivo Welch defined it in a 1992 paper in the Journal of Political Economy. Everyone has some information of their own but sees only that. What they see of others is their decisions. Once a few people have done the same thing, the next ones follow, and their own information no longer reaches anyone.
The authors also show the other side: cascades are fragile. Because they rest on so little information, a small shock, such as a piece of news or a few people stopping, can suddenly flip what many people do. A herd that was buying can become a herd that is selling.
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Create a free accountThe dot-com bubble: what happened to the Nasdaq in 2000-2002
In the late 1990s, internet companies looked like the future and almost everyone wanted a piece. The Nasdaq Composite, packed with technology firms, climbed until March 2000. Then came a fall that lasted 31 months.
Why it is hard to stay out when everyone is buying
They can, if most of them copied a few. A crowd usually shows how much confidence there is, not how much information.
When others gain, staying out feels like a loss, even though your own money hasn’t moved.
Keynes wrote in “The General Theory” that it is better for reputation to fail conventionally than to succeed unconventionally.
How to protect yourself from herding
- Write down what you knowBefore you look at what others are doing, note why you would buy and at what price. That shows whether your decision starts from your own information.
- Ask whether you’d buy without the noiseWould you buy this share if nobody were talking about it this week?
- Cap the amountFor fashionable ideas, a small sum decided in advance that you can lose without changing your plan.
- Leave a day between urge and orderThe 24-hour rule from the Beginner lesson on FOMO.
If you trade short term, the Trading School lesson “FOMO and chasing the price” shows what happens to your stop and your risk/reward when you buy after a big move.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: Bikhchandani, Hirshleifer and Welch, “A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades”, Journal of Political Economy (1992); Reuters (23 April 2015) for the Nasdaq record of 10 March 2000, the 2002 low and the new record; CNN Money (9 October 2002) for the 1,114.11 close; Keynes, “The General Theory”, chapter 12. The reports exercise is an example built for this lesson.