Friday, March 13, 2009

Investor unconventionality -a behavioral way to fix capitalism

Are we doomed to experience historically wider fluctuations in all financial markets going forward?

We know that there are more and more finance practitioners out there whose sole purpose and economic livelihood is to shuffle assets around, i.e. trade. We also know that, increasingly, more specialized information previously unavailable to a multitude are becoming more ubiquitous, allowing more analytical symmetry among investors, if not exactly 100% information symmetry.

So……as more and more investors are aware of the same new information, and making investment decisions based on the same homogenous analytical framework, we find more and more of them chasing the same high yield investments as each other. Their investment choice correlation becomes 1.

This herd behaviour reinforces everybody’s strongest convictions, and makes both their biggest hopes and fears come true. As events converge, and investment outcomes for a broader array of investors become they same, investor behaviour becomes the same. For example, widespread expectation of inflation makes everybody bullish on commodities, deflation expectations make everybody bullish on cash, depression concerns make everybody run for the exits, and so on and so forth.

As investors begin to make the same reactions and counter-reactions, strategic moves become crowded, with investors piling up after one another trying to beat each other to the bell – in every financial market, in every investment asset, in every investment locale.

Conditions previously-considered black swan events therefore become more common. A black swan event in an extreme end of the spectrum can then lead on to the black swan event in the other extreme event of the spectrum, and then on and on. Could we consider the widespread acceptance of toxic CDOs, the massive leveraging, and the massive use of complex derivatives black swan events in themselves, as much as the financial implosion that followed?

Could collective mass hysteria on a global scale be as much a black swan event as the probability that the world can experience collective bullishness, and that hey could adopt a collective belief that the world is getting better just because they are reinforcing each other’s collective bullishness?

Perhaps we should start celebrating individual, institutional, and national differences, rather than encouraging more than global homogeneity. We should encourage more people imbibed with unconventional thoughts than those who merely make the same conclusions as everybody else.

Perhaps then, capitalism becomes powered once again by the invisible hand of the market (which is supposed to achieve more stable equilibriums over a longer period of time), rather than the strong arm of manias (which leads to constant waves of reflexive outcomes and disruptions).

No comments: