Imitation can suddenly raise cross-asset correlations and defeat diversification.

Evidence

The possibility of imitation-induced correlation tightens the limits to arbitrage caused by the risk, discussed above, of the “flight” of capital-constrained arbitrageurs in the face of temporarily adverse price movements. If correlations between different arbitrage positions could be relied upon to remain low, the risk of forced flight could be reduced considerably by holding a large portfolio of diverse arbitrage positions, as Shleifer and Vishny acknowledge (1997, p. 47). However, as LTCM found, diversification is of little avail if correlation can suddenly appear around the world and across asset classes when things “go bad.” — Donald MacKenzie, An Engine, Not a Camera, 1229

Categorization

• XREF: Plugs into the ‘correlation goes to 1 in a crisis’ theme familiar from 2008 discussions; directly services the book’s performativity-of-models argument. — connects to: Security design boosted cross-market correlation and turned local losses into systemic collapse. — Mark Blyth, Austerity: The History of a Dangerous…, 96; Imitation-based microstructure can defeat the risk reduction promised by diversification — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1089; Imitation among firms can produce either stable niches or disastrous crowding. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1227