Crises on financial markets can result from 'information cascades', when investors opt to go with the crowd rather than take their own independent decisions – in behavior known as 'following the herd'.
According to information cascade theory, herd behavior is first expressed by several people taking identical decisions. This can happen in the following way: two traders base their choice to buy shares on erroneous information. A third, ignoring their own objective data, follows their example, believing them to have had information supporting their decision, rather than taking a different decision. Other investors then, rationally, follow those three traders (arguing, logically, that the traders who took those decisions had information supporting those decisions) – thus triggering the 'information cascade' of erroneous financial decisions.
Economic theory suggests that individuals should evaluate their own information and that received from external sources (other people) equally closely. And in this context, it is understandable why a trader can make an error based on information that quantitatively (in terms of the number of opinions expressed) exceeds his own.
However, experiments undertaken by psychologists in the 1990s indicated that, in most cases, when confronted by a choice, people are more inclined to trust their own information than social information.
Nonetheless, cascades of erroneous decisions, made when people ignore their own – correct – information do take place. Vasily Klyucharev and his colleagues, Rafael Huber and Jörg Rieskamp have carried out an unparalleled experiment to examine the mental mechanism underlying these information cascades. This is the first time research into informational cascades has been carried out from a neuro-economic perspective (an interdisciplinary area of academic research at the meeting point of neurobiology, psychology, economics, and decision-making). An article outlining the results of their research has been published in the magazine Social Cognitive and Affective Neuroscience.
The initial research and reports on informational cascade theory appeared in the 1990s. Several years later, the events of the 2000s clearly demonstrated the results of herd behavior on the financial markets. 'For example, in 2007, one could observe this destructive phenomenon – a bubble in the U.S. real estate market,' Klyucharev said. 'The rise and fall in shares in dot.com companies seen 1997-2000 is another example of herd behavior among investors.'
'One cannot say that all crises are based in people's tendency to go with the crowd. A financial crisis is a complex phenomenon that requires multifaceted research,' Huber notes, unwilling to make grand conclusions. Nonetheless, the research demonstrates the extent to which the situation on the financial market depends on mechanisms at play in the human brain. A particularly clear example of herd behavior comes in the fashion world, and in areas of professional activity in which decision-making depends on colleagues' opinions.
The researchers have set out to understand the mechanisms underlying information cascades at brain-level in the individual who launches the cascade and in the brains of those who largely rely on information from the people around them – in the information cascade. A most interesting thing happens at the very start of the cascade, when two people have already taken a decision and a third must make their choice, based on their own information and that relating to the decision made by the two other people,' the researchers said.
Twenty-seven people, men and women aged between 20 and 29, took part in this research. During the experiment, the subjects were placed in an MRI scanner. Over a 20-minute period they were asked to make decisions in 32 modeled situations regarding share purchases. In each case they were asked to choose between two shares. The researchers had access to their own information on the one hand, and on the other – information on decisions made by 2 other traders.
The experiment confirmed the results of behavioral experiments – the overwhelming majority (24 out of 27 people) showed that they would place more weight on their own information when making decisions. However, the researchers were interested in the mental make-up of those individuals who triggered an informational cascade.
The researchers shed light on how different people's brains respond to uncertain situations in which they have to make a choice between individual and social information.
'Uncertainty is a very interesting phenomenon from the psychological and neuro-economic perspectives. It creates a mental conflict,' Klyucharev said. 'And has two components: cognitive (cold) i.e. when we carry out a rational calculation and understand that we are in an uncertain situation, and the emotional – when we respond to uncertainty. Two different parts of the human brain are involved in this response: the temporal cortex and the insular cortex.
According to research, the insular cortex is activated when an individual experiences a strong emotional response, such as grief or disgust, and the temporal cortex, when they have to do math or carry out calculations.
The research carried out by Klyucharev and his co-researchers shows that the more active the emotional cortex response in evaluating individual economic information, received on the market, the less likely people are to launch an information cascade, i.e. be governed by social, not personal information, in making financial decisions.
Interestingly, when receiving individual information, these people displayed less activity in the area of the brain linked with cognitive, rational, processing of information. Logically, based on these results, it can be assumed that cascades of erroneous decisions on the financial markets can be triggered by individuals whose brains are more likely to take a cold, rational approach to processing individual information. And these individuals are, the experiment showed, in the minority. Most people, when receiving individual information, display an active emotional response and sufficient resistance to triggering information cascades.
The research results do not fit into a classic mathematical model of economic theory according to which people should appraise personal and social information equally rationally, Klyucharev says. 'Most people are still inclined to react to personal information emotionally, not to act like robots,' the researchers conclude.
Essentially, the research corrects information cascade theory. 'Cascades indeed occur, but not as often as economic theory suggests,' Klyucharev noted. 'But it is important to recall that if an informational cascade has already taken place, and you're too late on the market, then under any theory you're unlikely to be able to resist. What can you do with this personal 'correct' information, if millions of other people are selling shares – prompting a stock market collapse?' he added. In these situations the law of herd behavior is already well in place.
That said, researchers note that herd behavior is not, in itself, negative. It is never possible to be completely sure what you are dealing with – a cascade of erroneous decisions or, conversely, a cascade of optimal decisions, the researchers stress. In this case, herd behavior is justified. 'In our culture there is the concept that herd instincts are a bad thing. But often it is important to follow those around us, it is rational. And this is confirmed by many theories, including information cascade theory,' Klyucharev says. At the same time, herd behavior can lead to crises developing on the market.
Therefore the research carried out is one of the puzzles in this potential mosaic, which illustrated the mechanisms by which financial crises transpire, Rafael Huber noted. But in order for these mosaics to be revealed, it is important that this joint research work between economists, neurobiologists, social psychologists and specialists in other areas continues.