Learning, Cascades and Transaction Costs

Both market practitioners and academic economists have recently shown renewed interest in herd behavior in financial markets.1 Much of the literature on market microstructure holds that when agents are asymmetrically informed and trades occur sequentially, the market should gradually learn the fundamental information possessed by market participants, so that prices should eventually converge to fundamental values.2 In the long run, therefore, asset markets are viewed as informationally efficient. However, many interesting regularities observed in capital markets are not easily addressed under the efficient-markets hypothesis. Many of them can be explained by herd behavior.3 For example, the empirical evidence on episodes of soaring prices and subsequent collapse, like the Dutch Tulip Mania in the seventeenth century, the stock market crashes of 1929 and 1987 and, more recently, the international financial crisis in southeast Asia in 1997-8 and the overpricing of US technology stocks in the late 1990s, would be consistent with short-run mispricing caused by rational herd behavior.4 Also, the recurrent high volatility of financial market prices even in the absence of justifying news could be the consequence of information aggregation failure due to herding.5 Originally, imitative behavior was not considered rational: herds were described as peo-ple blindly following others.6 More recently, however, the literature on social learning has reconciled herd behavior with rationality in many economic environments.7 The models of informational cascades – that is, situations where imitative behavior leads market par-ticipants to disregard completely their own private information – belong to this strand of literature on “rational herding”.8 1See Hirshleifer and Teoh [7] for a survey on the theoretical and empirical literature on herd behavior in capital markets. 2See Glosten and Milgrom [6], Kyle [9]. 3See Kortian [8] for an extensive review of recent theoretical literature on asset price formation and capital market behavior