During the run-up to a crash, population diversity falls. Agents begin to use very similar trading strategies as their common good performance begins to self-reinforce. This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilizing impact on the market. The economic mechanism here is clear. Traders have a hard time finding anyone to sell to in a falling market since everyone else is following very similar strategies. In the Walrasian setup used here, this forces the price to drop by a large magnitude to clear the market. The population homogeneity translates into a reduction in market liquidity.

Blake LeBaron, "Financial Market Efficiency in a Coevolutionary Environment," Proceedings of the Workshop on Simulation of Social Agents: Architectures and Institutions, Argonne National Laboratory and University of Chicago, October 2000, Argonne 2001, 50.

Riz Din remarks:

Reminds me of the extreme robustness of the naturally diverse rainforest, and of how relatively small changes can destroy single crop plantations.

George Parkanyi writes:

I'm not so sure that's as true anymore. There are many new instruments such as commodity and short ETFs that create more possibilities for risk mitigation and alternative strategies. Perfect opposite correlation is an asset-allocator's dream. I would think most trading volume comes from mutual and pension funds. If they change their charters, or simply interpret short ETFs to be another asset class, then the herd mentality may dissipate somewhat as there is now less reason to sell in a panic. Hedge funds and individual investors already have the bi-directional option available to them. For example, I recently used short ETFs to blunt the decline of the past couple of weeks. I felt less pressure to sell my stocks that did go down — in fact I bought more — because I had money working in the other direction. I'm theorizing that markets will tend to become more choppy and less smoothly trending, even in a broad decline, for this reason.


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