Imitation-based microstructure can defeat the risk reduction promised by diversification

Evidence

The “nature of the world had changed,” says John Meriwether, “and we hadn’t recognized it” (Meriwether interview). LTCM’s wide diversification, both internationally and across asset classes, which lie had thought kept aggregate risk at acceptably modest levels, failed to do so, because of the effects of a global microstructure rooted in one of the most basic of social processes: imitation. — Donald MacKenzie, An Engine, Not a Camera, 1089

Categorization

• XREF: Directly challenges the efficient-markets/diversification orthodoxy that LTCM’s own model embodied — core performativity tension. — connects to: Diversification across geographic mortgage pools created rather than removed correlation. — Mark Blyth, Austerity: The History of a Dangerous…, 97; Imitation can suddenly raise cross-asset correlations and defeat diversification. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1229; Fundamentally unrelated market phenomena can suddenly move in lock-step within a global microstructure — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1088 (+7 more)
• DEEPTHINKING: The irony that the model which promised diversification against risk is precisely what concentrated correlated risk via imitation is a dense, layered point worth sitting with.

Broader Connections

• Imitation can suddenly raise cross-asset correlations and defeat diversification. #corroborates (0.95) — Donald MacKenzie, An Engine, Not a Camera, 1229
• Fundamentally unrelated market phenomena can suddenly move in lock-step within a global microstructure #expands (0.85) — Donald MacKenzie, An Engine, Not a Camera, 1088
• Less sophisticated mortgage traders reverse-engineered competitors’ models by observing their trades #exemplifies (0.85) — Donald MacKenzie, An Engine, Not a Camera, 1023
• Market microstructure shapes price behavior independently of underlying fundamentals #responds-to (0.80) — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 88
• Post-crisis risk models internalized social imitation as a financial risk factor. #complicates (0.80) — Donald MacKenzie, An Engine, Not a Camera, 1231
• Computer-generated complexity caused herd buying of incomprehensible derivatives #exemplifies (0.75) — Yanis Varoufakis, Technofeudalism, 223