Investors Should Beware When They Start To See ‘Information Cascades’

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During his recent interview with Tobias chats with Jim O’Shaughnessy, best selling author and Co-Chief Investment Officer at O’Shaughnessy Asset Management (OSAM), discusses why investors should beware when they start to see ‘information cascades’. Here’s an except from the interview:

Jim O’Shaughnessy: The stock market is a complex adaptive system with feedback. The reason that it works so well is because people have heterogeneous interpretations of things right. Toby might buy my Apple stock from me because he’s going to get married or he has a child or whatever, and he wants to fund that child’s future education. Jim is 58 and has a grandchild, he might want to sell that so that he can help pay for the grandchild’s education right. Neither one of us is wrong right. I’m right because of why I’m selling it, for the reason I’m selling it. You’re right for the reason you’re buying it right.

Jim O’Shaughnessy: That’s why markets generally clear and why markets are great aggregators of information right, the wisdom of crowds type thing. However, I also had a corollary theory that was attached to that which was rarely, maybe call it 10% of the time, things that I at the time and still call information cascades happen. What’s an information cascade?

Jim O’Shaughnessy: An information cascade is where all of the information is going in one direction only and very importantly, all of the investors interpretations of that data are the same. Objectives are no longer heterogeneous, they’re homogeneous. We’re all thinking the same thing. Which led me to this deep dive study that I’ve done on memetic behavior right. By the way it’s fascinating. You’re head spins because it’s really been around, the name is different right. Memetic behavior, but Plato talked about it right. The simple version of it is we do things by copying other human beings. Pretty simple.

Jim O’Shaughnessy: Then we don’t know that right, we don’t know we’re copying them, and we invent rational reasons for our behavior after the fact. Especially in these situations where we have an information cascade, everybody is interpreting that information the same way, interpretations become homogeneous right, and the memetic drive, making the guy who wrote the most bearish article on the internet started an internet company right. I’m the perfect idiot example here.

Jim O’Shaughnessy: It overwhelms us. It overwhelms us to such a degree, and you know we could a whole pod cast just on memetic behavior and the transference through memes right of behaviors both good and bad, and how they infect the mind right. I think it was Dawkins who came up with the term gene, he also came up with the term meme and called it you know a virus of the mind. Actually there’s a book, a good book, of that title Viruses of the Mind about memetic behaviors and transference and everything like that.

Jim O’Shaughnessy: The reason I have to get into all this stuff is A: I want to understand why is this happening right. B: can I quantify it? Is there a way to quantify this? Then see is there a quantitative signal that I can develop that says information cascades happening, event happened, run for the hills. In other words, it happens at watershed turning points.

Tobias Carlisle: Can you apply that to the 2007 real estate crash? How does the meme manifest in that particular point in time?

Jim O’Shaughnessy: Let’s be careful, I can’t empirically yet prove my thesis. I haven’t been able to fully test my hypothesis. Dirty little secret, about half of what I do on Twitter is in service to a lot of the research that I’m doing. I also want it to be fun. We have through the brilliant program that Patrick started, the O’Shaughnessy research partners. We have some of the brightest machine learning guys in the world on our partnership team. I was on the phone about a month ago with one of our lead guys, and I love engineers because they immediately just start solving the problem right. They’re like “Oh, well we could do this, we could do this” you know.

Jim O’Shaughnessy: Anyway, we don’t yet have any empirical proof that I could offer to you. My theory is that during the CDO and real estate crisis that yes, we had information cascades had happened. People’s interpretation of what was going on became homogeneous except for very few which were written about in the great book The Big Short by Michael Lewis and made a movie. How they made a movie, an enjoyable movie at that, about that I mean that’s genius right there.

Jim O’Shaughnessy: Anyway, yes that’s what happened. What happened was everybody was behaving memetically. I sat in on several pitches for hedge funds that were you know going along short CDOs. They were mostly going long, mostly with huge leverage. You know if you learn anything in stock market 101, it’s that if you want a prescription that always works if you want to fail is you use 40 times leverage on illiquid instruments. It’s not if you’re going to die, it’s when you’re going to die. You’re always dead.

Jim O’Shaughnessy: Yeah, that’s what was going on then. It’s what was going on during the dot com frenzy. You know we’ve got Jamie now works for us, the financial history guy, and I know you know Jamie well. You know he’s very good at showing that it went on all the way back to the Babylonians right. Anything new and exciting ignites the human imagination as I understand why it should right.

Tobias Carlisle: In the ordinary course, in the ordinary stock market it’s heterogeneous. We have different reasons for buying and selling. Then in these booms and probably or so in the bust we become homogenous in we’re all pursuing the same thing. We see the dot com is going to be huge, so we all want to be buying dot com stocks and then eventually it busts so we all want to be out or short of the dot com that applies again in real estate and then possible in crypto. In the recent run up it becomes sort of overwhelming. You might be able to use something like Twitter or a web search to either count the number of times that crypto or something like that appears.

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