What does this mean? A lack of diversity. We discuss this topic in our upcoming book Pitch the Perfect Investment, in Chapter 6: How to Think About the Wisdom of Crowds. For a stock to be efficiently priced, a diversity of models (we use the analogy of different car models) among market participants is critical as we show in the figure below:
In the book we state:
“…diversity, requires that a sufficient number of individuals in the crowd have different backgrounds, education, experiences, or analytical approaches, and use different models to process their observations.
The crowd’s diversity will be lost if everyone has the same facts and expertise, or starts thinking the same way by using the same mental model. And without diversity, individuals within the crowd produce similar answers to each other, the crowd’s guess will be only a small deviation from the individual estimates, and the crowd’s consensus will reflect nothing more than a single view. Consequently, the crowd’s answer will lack any of the benefits of diversity and will likely result in a mispriced stock.”
We represent the lack of diversity of models as everyone driving the same car and show that everyone using the same model can create a mispricing:
In Chapter 7: How to Think About Behavioral Finance we specifically discuss how a lack of diversity can cause a crash:
“There have been many situations in the real world where crowding or herding among investors exists in an individual stock or market sector, resulting in a lack of diversity among the market participants in that particular area of the market. Because most of the market participants in these situations are using similar models in their analysis, a small, seemingly innocuous event can trigger a stampede, causing Mr. Market to become manic. We want to emphasize that an “appropriate” reaction to an event by an otherwise diversified shareholder base can easily turn into an overreaction to the same event when the shareholder base lacks diversity.
One such incident was the Quant Crisis of 2007. Quantitative investors use computer models to identify patterns in securities prices and then buy or sell thousands of different securities to capture small mispricings. It has been an enormously successful strategy over the years and has made billionaires of investors like James Simons of Renaissance Technologies, Ken Griffin of Citadel, and Cliff Asness of AQR Capital. However, sometimes a successful strategy breaks down and causes pandemonium.
Several large hedge funds and proprietary trading desks on Wall Street began losing billions of dollars over a matter of a few days in early August 2007 and no one knew exactly why. Because the majority of these funds were implementing a similar strategy (using the same models) and employing significant amounts of leverage, many of them received margin calls simultaneously when prices started to decline (the securities they held were the collateral for their loans) and were forced to sell at least some of their holdings. Unfortunately, because many of the portfolios were similarly constructed, the margin calls created a ripple effect, and the selling begat more selling, which resulted in a “death spiral” in many of the widely owned assets.”
Keep in mind, it is not the quants or index funds that can pose problems per se, rather, the underlying cause is a lack of diversity.
To download the introduction to our book go to our website www.pitchtheperfectinvestment.com or pre-order our book on Amazon.