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Jun 19, 2010

Economist's View : Tail Risks, Time Lags, and Herding Behavior. June 19th., 2010

Economist's View


Tail Risks, Time Lags, and Herding Behavior

Rajiv Sethi explains how herding behavior toward high risk outcomes can occur, and how this can happen without assuming the kinds of departures from rationality observed in behavioral economics:
[For] tail risks...: there can be a significant time lag between the acceptance of the risk and the realization of a catastrophic event. In the interim, those who embrace the risk will generate unusually high profits and place their less sanguine competitors in the difficult position of either following their lead or accepting a progressively diminishing market share. The result is herd behavior with entire industries acting as if they share the expectations of the most optimistic among them. It is competitive pressure rather than human psychology that causes firms to act in this way, and their actions are often taken against their own better judgment. 
This ecological perspective lies at the heart of Hyman Minsky's analysis of financial instability, and it can be applied more generally to tail risks of all kinds. ... As an account of the (environmental and financial) catastrophes with which we continue to grapple, I find it more compelling and complete than the psychological story. And it has the virtue of not depending for its validity on systematic, persistent, and largely unexplained cognitive biases among professionals in high stakes situations.
More here.

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