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How do you deal with a risk that has never been seen before? I'm going to focus on financial risks here, but clever people can generalize to other classes of human risk, like war and terrorism.

By "emergent phenomena" I mean what happens when people act as a group pursuing the same strategy. One person doing a given strategy means nothing. But when millions do it, that can be significant. Same for corporations, but the numbers are lower, because corporations are far bigger economically than the average household.

Here are some examples of emergent phenomena:

  • 1987 - Strategies for dynamic hedging became a large enough part of the market that the market became unstable, where parties would buy as the market rose, and sell as the market fell.
  • Tech stocks were the only place to be 1998-2000, until they weren't 2000-2003.
  • Too much hedge fund money was playing the quantitative value plus momentum trade in 2007. Many players borrowed money to goose returns in 2006-7. It blew up in August 2007.
  • The fear of not getting "free money" caused many to over-invest in residential real estate 2004-7, until the free money was not only not free, but billing you for past indiscretions.
  • There was a frenzy among commercial real estate investors toward the end of the 1980s, which bid prices up amid more buying power from then-cheap commercial mortgage debt, leading to an overshoot, and fall in property value in the early 1990s.
  • In 2005, the CDO Correlation Trade led to a panic in the corporate bond market, and in auto stocks.
  • Into the late 1980s, Japanese households and some foreigners plowed progressively more liquid capital into the Japanese stock and warrant markets. That was the peak, and few if any have made their money back.

Emergent phenomena stem from:

  • Many people and institutions doing the same thing at the same time.
  • Using debt to substitute for equity in a trade that has become a "sure thing."
  • Multiple companies and industries pursuing essentially the same trade, but in different corners of the markets. (Think of the real estate bubble. There were so many different angles that the bulls played: mortgage insurance, financial guaranty, subprime loans and derivatives thereof, weakened lending standards on prime loans, etc.)
  • And it is more intense when economic agents borrow short term to finance their efforts, because when things go wrong, the feedback loop is quick.

Everyone runs to the exits in a burning theater, and so, fewer get out amid the struggle than if everyone patiently walked out. In financial terms, this is why markets are more volatile than expected, particularly on the downside. Too many people want to sell in a panic, after having pursued a well-known strategy that had been successful for quite a while.

But no tree grows to the sky. The intelligent investor notes several things:

  • Where is the most new debt being applied, and to increasingly little effect?
  • What fad are players investing in, that you think can't be maintained in the long run?
  • What is happening that would not be happening if it were not for price momentum?
  • Where are players relying on price appreciation or else their levered positions will collapse?
  • Where is money being borrowed short term to fund long-term assets?

People are prone to imitate past success, even when a rational person would conclude that it doesn't make any sense to borrow money and buy an asset at a high price. It's easier to imitate than to think independently.

In the present market, I see large increases in government debt and student loans. Beyond that, there is the income craze in investing. Don't look at the yield; look at the underlying business.

Be wary. The stock market has run hard the last ~5 years, and I see valuation-sensitive investors retreating. Even with bond rates low, that doesn't mean stocks are better.

Source: On Emergent Phenomena