Technological innovation and real investment booms and busts by Peter DeMarzo, Ron Kaniel, and Ilan Kramer makes some interesting observations about human investment behavior and cascades. The paper is summarized nicely on the following link here. The article describes the reasons behind such bubbles that preceded events like the 1929 market crash or the dot com bust in the 90s. As stated in the previous link, the paper found that “what investors fear the most is not the risk of a loss. It’s the risk that they may do poorly relative to their peers.” Essentially, people do not generally care about how wealthy they are individually, but how wealthy they are in relation to those around them. This externality induces a cascading effect. People tend to make the same investment decisions as their neighbors in order to avoid being poor relative to them. When those around them are making high risk investments with large potential payoffs, an investor will want to make the same investment solely to avoid the potential of being left behind financially. When this cascade happens, the worth of the investment bubbles disproportionately.

This behavior also has the effect of making a significant loss have less impact on an individual investor because every one of his peers has suffered a similar loss, and his wealth relative to his neighbors has not significantly changed. This mentality often centers itself around investment in technological innovations that have the potential to completely take over the market and promise large returns but will in most cases bust. As explained in the paper summary, it was this cascading behavior that caused investors during the dot-com bubble to ignore valuations on internet based companies, and pay several times what the expected earnings for the investment were.

In class we discussed when cascading occurs because people are trying to make informed decisions on something based on what other people around them have done, in order to maximize his/her own payoff. However, in the examples stated in the article, an investor is more concerned with how others are doing relative to him than how much he personally gains / loses. As evidenced in the dot-com bubble, this can lead to irrational investing not based on good information as much as the fear of being left behind by ones peers. By gaining and losing together, investors never have to fear being left behind, while they will also never really pull ahead.