Information Cascades - an article by Robert Shiller

[TJ_98370]

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At the end of the article, Mr. Shiller suggests the possibility of a housing "unbubble" (opposite of bubble) developing in the future.

by Robert J. Shiller

ONE great puzzle about the recent housing bubble is why even most experts didn't recognize the bubble as it was forming.....

.....The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.

Were all these people stupid? It can't be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior.

Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call "information cascades" that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena.....

......The fundamental problem is that the information obtained by any individual — even one as well-placed as the chairman of the Federal Reserve — is bound to be incomplete......

.......As others make purchases at rising prices, more and more people will conclude that these buyers' information about the market outweighs their own.

Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.....

......Furthermore, these people are being influenced by agencies like the National Association of Realtors, which is conducting a public-relations campaign intended to show that putting money into housing is a reliable way to build wealth. Under these circumstances, it's easy to understand how even experts could come to believe that housing is a spectacular investment.

It is clear that just such an information cascade helped to create the housing bubble. And it is now possible that a downward cascade will develop — in which rational individuals become excessively pessimistic as they see others bidding down home prices to abnormally low levels.
..

[Alan]

I just read the chapter of that talks about why experts are really bad at predicting events like this. The book claims there is emperical evidence showing that the larger the reputation of an individual, the greater his error in predicting large changes.

[sniglet]

One theory I have as to why "experts" are often wrong, is the fact that they are so immersed in the trees that they can't see the forest. They can certainly tell you if one tree is healthier than another (i.e. because they sure know trees), but they might not grasp the risk that a bit of smoke over the horizon might actually be the harbinger of a massive fire that will engulf most of the entire plant stock. In the face of such a catastrophic fire, the fine minutiae defining the health and quality of one tree from the other are irrelevant.

It takes someone with a broader view, and less specialization, to see how the various factors interplay with one another, and really get concerned that the puff of smoke far away might actually be the beginnings of a raging inferno.

I also think that many experts suffer from an inability to make any analyses without good data. Sure, common sense might tell you that a market over-bought, and a bubble is forming, but where is the DATA to prove that a bubble exists? Greenspan, for example, has openly lamented his inability to find a smoking gun of data which would sufficiently prove to him there was a bubble until after the fact.

Until a bubble actually bursts, you can always find people who can justify the currently valuations with all sorts of rational arguments. It is only the collapse in prices that proves their reasoning was specious hollow.

[TJ_98370]

I find Mr. Shiller's prediction of a possible "downward cascade" most intriguing. I interpret that as being the overshoot (undershoot?) of the reversion to the mean that some have been predicting on this blog.

[rose-colored-coolaid]