Tuesday, February 3, 2009

Changing odds

The Economist, in its special report on the future of finance, included a nice little box called "When markets turn". I was quite struck by this point [emphasis added]:

After Wall Street bailed LTCM out, Mr Meriwether quoted his colleague, Victor Haghani, on how other firms had traded against it: “The hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen.”

It was an example of something that Mr Soros calls “reflexivity”. Once people come to believe that house prices never fall, they will buy too much property—and house prices will fall. When they believe that shares always do well in the long run, they will buy too many shares—and the market will do badly for years. When funds believe that diversification always pays, they all invest in the same exotic instruments. Diverse markets suddenly have something in common: the funds that have bought into them.

People often talk about financial markets as if they were casinos, but reflexivity makes them much more dangerous than any gambling den. The numbers on a roulette wheel never change, but markets offer no guarantee that yesterday’s odds will be the same tomorrow.

I haven't seen this said anywhere else, and it makes a lot of sense to me in terms of financial fads and the nature of bubbles. The report discusses the inevitability of bubbles quite a bit and this is a nice encapsulation of why they're so unavoidable. In these cases, every good idea is a bad idea when it becomes universalized, and competition dictates that good ideas will be universally applied.

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