In the last 12 months the Indian capital markets have experienced wide fluctuations. The SENSEX (which can be considered the Indian equivalent of the S&P 500 index of the New York Stock Exchange) hovered around the 12,500 mark in April ’07. Over the next 8 months it rose almost steadily and reached a peak of about 20,500 in early January ’08 (an increase of about 85%) and then started its downward journey and currently hovers around the 15,000 mark (A fall of about 30%). One can only imagine the excitement and fear generated by such heavy turbulences in the stock prices. [The S&P 500 has plunged by only 15% since January ’08 and the threat of the US economy meltdown is being felt everywhere] The Yahoo! Finance charts below graphically depict the movement of SENSEX and S&P 500 for the last year.

Many theories have been put forward to explain the shift in the markets, but what we are interested here is the fluctuation in the number of new retail investors entering the market. During the 6 month period when the stock markets kept rising continuously, there was also a tremendous increase in the number of retail investors. During October ’07, when the stock market was rising steadily, the depositories in India received 365% more requests for new accounts than they had in September ’07. Similar increases in the number of retail investors were also noted for October and November ’07. But, following the crash of January’08, the number of new depository account requests began to fall. A growth of -56% for February’08 and -53% for March ’08 was recorded.
Could an information cascade generate this trend among the retail investors in India? Experts at the India Knowledge Center @ Wharton business school say yes.
The decision to invest or not to invest can be seen in light of game theory. The early, presumably knowledgeable investors who decided to invest led to an information cascade that made others follow. Most of these new investors had little private knowledge to aid them in the decision making process. So, they relied of the public information (for example news reports about the booming Indian economy and the profit made by a few initial/early investors) floating in the media and on the decisions made by others before them. This caused the cascading effect in which every new comer decided to invest. Thus every subsequent investor, based on the decision of others, made the same choice independent of his/her private signal (which might have even been the decision not to invest).
The new investors here later also experienced the fragility component of the cascading effect. The unusual/sudden falling of the stock prices acted as an unusual signal and this overturned the long-standing informational cascades. This information caused all the new investors to do choose the opposite action which was the decision to not invest!
References:
http://economictimes.indiatimes.com/Markets/Bear_grip_sees_fall_in_new_demat_accounts/rssarticleshow/2921363.cms
http://www.info-cascades.info/
http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4263
http://www.littleindia.com/news/127/ARTICLE/2321/2008-03-12.html