So the US election ended with a Trump win and wild swings in the stock
markets. The Dow Jones fell from 18,200 to 17,900. Then, less than a week
after, stock prices rushed back up and passed 18,800. What happened? Let’s start with the simple
observation that we were observing stock sales and buys by investors, who sell
and buy for profit, and who have a lot of experience selling and buying. These
wild movements were not a result of ignorance, and not a result of playfulness
either. Investors chasing value drove prices down and back up, and lost and
gained money. And, this was not a unique event, we are familiar with dramatic
price changes as the market responds to uncertainty.
What drove these events was in fact a fundamental process that
has been studied long, and we can go back to a paper by Hayagreeva Rao, Gerald Davis, and myself in Administrative Science Quarterly in 2001 to learn about it.
People making decisions under uncertainty try to learn ways to reduce
uncertainty. When they are looking for value, one way is to learn from others.
After all, if we see someone moving toward one option, or away from it, their decisiveness
could indicate that they know something that we don’t know. But people can be
decisive for many reasons. They may have correct knowledge. They may have incorrect
knowledge. They may be impatient. But learning from others can be very tricky
when those others act on incorrect knowledge or impatience. This was known
before our study.
What we found went one step further. Learning from others is
especially tricky when those others learn from others. In that case, it is enough
for some people to make decisions without correct knowledge. Others do the same
learning from them, and then others do the same learning from those who learnt
from them. And so on. See how this can make stock markets plunge, with very
little basis in fact? Or increase? In fact, our research was based on stock
market actors – not investors, but stock analysts. They want to cover firms
that are good but overlooked, because analysts are most useful for investors if
they give scarce information on valuable opportunities. But we found that when analysts
were chasing valuable firms, they were in fact only chasing other analysts. And
the later they were in learning from others, the less valuable were the firms
they found.
This is a problem that extends much further than stock
markets, though it is easier to prove
there than elsewhere. Learning from others is a good strategy as long as it is
not over-used. But, those who learn from others typically don’t stop using that
strategy soon enough, so at some point it becomes costly. Again and again we
see people, and firms, chasing fool’s gold: opportunities that looked good to
the first who entered, but only because of incorrect information.
