Pragmatic Capitalism

Practical Views on Money, Finance & Life

Leverage Causes Fat Tails and Clustered Volatility

Good paper here via  quantivity on Twitter discussing the effect of fund managers borrowing on margin to purchase assets.  This is something I’ve discussed previously in my many posts on margin debt and why it matters (see here for a good explanation or just read on).

Many analysts correctly note that margin debt is a coincident indicator, but that misses the point. Borrowing on margin can exacerbate volatility in both directions by helping fund managers to purchase more of an asset than they normally would.  The reasoning for this is rather simple and it’s classic herding behavior, recency bias and optimism bias.  When the market rallies it often becomes a self fulfilling prophecy in which recent positive performance causes overconfidence about future performance.

When the herd becomes overly optimistic it can result in volatility clusters which lead to abnormal divergences from the mean and what looks like a permanently high market.  As the herd grows this effect is magnified.  And one way the herd grows is by essentially borrowing to make the herd larger than it really should be.  So fund managers borrow to purchase more stock and irrationally bid up prices.  The problem is that this works both ways – on the upside and the downside.  And when the market reverses the herd reverses course causing not only a negative psychological volatility cluster, but the margin call effect in which fund managers become FORCED sellers of positions.  If you remember 2008 and talked to any fund managers during that period you know what I mean.

Anyhow, a lot of this is common sense stuff, but it’s important.  Of course, right now, the herd is running full steam ahead and gaining momentum in large part thanks to borrowing (see here for the data).  Said differently, the supposed stability creates overconfidence which can lead to instability (and greater risk as investors become more confident of future market action).  Who knows when it reverses course or why, but if it does you’ll want to make sure you’re not in the way of this stampede.  It looks like a mighty big one already.

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