Monday, December 3, 2007

Financial Wisdom Might Be Part of an Information Cascade. BEWARE!!

Here's a fact:
When CNBC mentions a stock with good news or bad, its price goes up. Effectively making an excellent stock trading strategy.

The assumption people are making is:
If CNBC thinks it is good, it must be good.
But wait, that implies the listener actually heard more than the ticker symbol and would not explain why bad news also causes the stock to go up. So the real assumption people are making is:
If you see or hear a stock mentioned on CNBC, BUY IT!!!!

That's right, there are millions of people just watching CNBC and then calling their stock brokers. The question I ask here is: Are you one of those millions?

But even if you don't buy stocks the behavior I described should cause you to evaluate your own decisions. Before I get to that, let me explain what might be causing the CNBC listeners to behave the way they do.

Wisdom of Crowds says the CNBC phenomenon is a kind of "information cascade." An "information cascade" is a kind of "group think" where people follow the group's decision without evaluating the facts for themselves. For example, I buy a stock because you think it's good, and my friend buys a stock because he sees me buying it, and my friend's friend sees my friend buying the stock so he buys it, and on and on. This can result in a group that does not have diverse points of view and thus makes some really bad decisions.

Alright, now this is all very interesting, so here's a fact that might really disturb you:

The most effective way to maximize your portfolio return is to diversify your investments among many loosely correlated asset classes.

I could have easily said "Save 15% to 20% for retirement" or "If you have 5-7 years to invest, do not worry about fluctuations in stock prices because the average return over the time period will be greater" or even "Don't save, invest in real estate!"

Admit it, how many times have you heard these statements? Have you analyzed the data yourself? Have you thought about these concepts? Have you considered alternative strategies?

Are you just participating in a long standing information cascade or is the wisdom really correct?

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