Monday, November 2, 2009
Economist Blake LeBaron has discovered an important cause of stock market crashes:
During the run-up to a crash, population diversity falls. Agents begin using very similar trading strategies as their common good performance is reinforced. This makes the population very brittle...In other words, when everyone is making the same trade, it will likely lead to a crash.
Tyler Durden summarizes this idea even more succinctly:
When everyone is on the same side of the boat, it always inevitably capsizes.A related concept is that - if your waitress or cabbie is telling you to buy something - that probably means that the market is overbought, and you might want to consider selling.