http://www.nytimes.com/2008/03/02/business/02view.html?pagewanted=2&_r=1&sq=information%20cascade&st=nyt&scp=1

One of my father’s favorite jokes is “What is the state bird of Florida? The construction crane!” For a time, I believed that the joke was more of a fact than a mere quip. Driving up A1A, a major thoroughfare that runs parallel to South Florida’s beaches, revealed hundreds of new condominium development project each soaring higher than the other. Yet, I could not help but wonder who would occupy these gargantuan structures. The short answer to my quandary was no one. The recent bubble in the housing market hit Florida especially hard because of the large amount of Real Estate speculation.

The recent burst of the housing bubble was presupposed by a tremendous information cascade. An information cascade occurs when rational individuals imitate the actions of others when their information suggests an alternative choice. Basically, an information cascade can be summed up by utterance “They must know something I don’t.” Sadly, this type of mentality usually occurs before major market turmoil like the housing bubble. Information cascades were an all to familiar part of the tech bubble of 2000. As the Dow and NASDAQ propelled upward quicker than rockets, many people risked their savings betting on a ’sure thing.’ As people watched their friends and family invest money in the burgeoning stock market, they began to believe that others had more knowledge than they did, despite knowing that investing is inherently risky. It is easy to let something go when just the Jone’s do it, but when the Jone’s, Smith’s, Doe’s all do something collectively, they must be on to something.

The housing bubble marks a similar denouement. “I’d come to realize that we’d never be able to identify irrational exuberance with certainty, much less act on it, until after the fact,” said former Federal Reserve Chairman Allan Greenspan. In fact, researchers have been able to calculate this risk, claiming, cascades lead to incorrect assumptions 37% of the time. With respect to the housing market, who could blame people for thinking Real Estate was a lucrative investment? With apartments in Manhattan fetching upwards of $20M and a new crop of television shows geared to flipping houses, the real estate market seemed ripe. However, what people did not know is that many of these homes were being purchased through risk adjustable rate mortgages that locked unknowing home buyers into a temporary teaser rate that floated with the prime. Once interest rates rebounded, people could not afford to make their mortgage payments and defaulted on their loans. Since a new glut of real estate hit the market and demand plateaued, housing prices plummeted.

An old adage in elementary school warned that what is popular is not always right. Such a phrase can describe an information cascade; however, it is quite difficult to go against the grain. Information cascades remind me of Solomon Asch’s famous experiment. Asch drew three vertical lines of differing length on a chalkboard. He then asked people to identify the longest line. His sample size was contaminated, however, as he planted confederates within the experiment that were told to submit the wrong verbal answer. The experimental subject—who had no knowledge the other’s were in on the trick—almost always agreed with the incorrect answer.