Posted by: Bevan | May 30, 2012

The Cause of Crisis and Abnormal Market Moves

I’m reading this excellent letter from Absolute Returns.  This quotation from economist Woody Brock is absolutely in the ball in explaining bubbles and financial crisis:

The more correlated the forecasting mistakes of the individuals in a market are, then the greater the market correction (and hence volatility) will be in the market once the Truth is learned. When
forecasts are uncorrelated and distributed symmetrically around the Truth, then once the Truth is learned, for every seller there will be a buyer and market price does not change. There is no volatility. In the case of a correlated structure, the reverse is the case: everyone becomes either a buyer or a seller in unison, resulting in sharp changes in price … In applying this insight to help explain the case study of the Global Financial Crisis three years ago, I arrived at what I have termed the Fundamental Theorem of Risk: A Perfect Financial Storm will occur when (1) investors have bets based upon very similar forecasts, (2) their bet is a “big” one, for example, a bet on the price of their principal asset (their house), and (3) both investors and their banks are maximally leveraged. It can be demonstrated formally that these three conditions will generate a Perfect Storm of maximal volatility — and note how perfectly these three conditions were met in the US housing market collapse. The role of excess leverage is to non‐linearly amplify market distress.

Something interesting to digest.

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