Excerpt: The Fearful Rise of Markets, 2010 and After
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The condition is easily diagnosed. Over the last half century, the rise of the investment industry has created overwhelming incentives for investors to follow one another into risks they often do not understand. As a result, world markets are hopelessly synchronized. This obstructs rational pricing and, in a capitalist world that relies on markets to set prices, endangers our prosperity. Finding a cure, however, is more difficult.
Some fixes are easy. The absurdly complicated instruments that created the subprime bubble, like synthetic collateralized debt obligations, should of course go. But the roots of the problem lie deeper. The institutionalization of investment cannot be reversed. Most of the financial innovations that created the synchronized bubble, like index funds, or even securitized mortgages, are in any case good ideas, so finding fixes will involve hard choices.
Making this harder, solutions must deal with human nature, our tendencies to suffer swings of emotion, to move in herds, and to expect that others will rescue us from the consequences of our actions. Over the last half century, the investing industry has unwittingly intensified those tendencies. Changing this requires a cultural shift; investors must have an incentive to treat others’ money as if it were their own.
Excerpted from The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How to Prevent them in the Future by John Authers (FT Press).