Chasing the Dragon
Kevin just posted about a great article by Felix Salmon in Wired. I underlined three quotes in my reading of it:
- “Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus.” (Tavakoli)
- “…the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.” (Salmon)
- “Co-association between securities is not measurable using correlation…. Anything that relies on correlation is charlatanism.” (Taleb)
The take-away I get from this is that boom-bust cycles are inevitable. Forget about protecting against the last one happening again, it won’t. The next one is unpredictable, a black swan. The longer we go on without one, the bigger and more certain the next one. Taleb even argues that because of the increasing complexity, interdependence and information feedback in the global financial system, the frequency and magnitude are increasing.
The question becomes (in my mind), can we keep these cycles from having far-reaching collateral damage to “innocents”, and snowball effects as we are experiencing now?
Is there a way to let the air out of the tires every so often, sort of a controlled burn, possibly trading higher frequency for lower magnitude?
Psychologically, we are wired to fear change and desire stability and predictability. But it seems that the illusion of stability and predictability is what gets us into trouble.
I only have the vaguest notion of what an economic controlled burn policy would look like, but the idea is that every so often (perhaps unpredictably) we change the rules and incentives that govern the financial markets. It wouldn’t be so important how they are changed, but rather that they are changed. Keep the markets (and by this I mean the market participants) on their toes, always reacting to and trying to figure out how to game the new system, but never actually reaching that point.