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.

Update: Brad DeLong:

Rajiv Sethi Misses a Point..., by Brad DeLong: Mark Thoma sends us to Rajiv Sethi, who writes:

Rajiv Sethi: On Tail Risk and the Winner's Curse: [T]hose with the most optimistic expectations will take the greatest risks and suffer the most severe losses when the low probability events that they have disregarded eventually come to pass. But tail risks are unlike auctions in one important respect: 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...

What Rajiv misses is that it may not be "in the meantime." To the extent that the optimism of noise traders leads them to hold larger average positions in assets that possess systemic risk, their average returns will be higher in a risk-averse world--not just in those states of the world in which the catastrophe has not happened yet, but quite possibly averaged over all states of the world including catastrophic states.

In general, noise traders' returns average returns are:

• higher because of their optimism about risky assets
• lower because their fluctuating opinions tend to make them buy high and sell low
• higher because their irrational changes of opinion make the risky assets they concentrate on even more risky--and so drive rational risk-averse investors away, push the prices of such assets down, and returns on such assets up.

There is another factor:

• it is possible for noise traders to have a higher average return and yet a lower median market share--repeated independent investments of agents with crra-like utiity functions tend to generate log-normal distributions, and because noise traders' distributions have higher variance they may have a greater expected wealth but a ower median wealth because of a long upper tail.

But Rajiv doesn't want to put his noise-trader optimists into a model with flint-eyedsteel-nerved ice-bloodedrisk averse rational calculators. He wants the other agents in his models to be:

[L]ess sanguine competitors in the difficult position of either following [the optimists'] 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...

I wouldn't say "rather than": I would say "along with." For, as my teacher Charles Kindleberger liked to say:

Kindleberger: Overestimation of profits comes from euphoria, affects firms engaged in the production and distributive processes, and requires no explanation. Excessive gearing arises from cash requirements that are low relative both to the prevailing price of a good or asset and to possible changes in its price. It means buying on margin, or by installments, under circumstances in which one can sell the asset and transfer with it the obligation to make future payments. As firms or households see others making profits from speculative purchases and resales, they tend to follow: "Monkey see, monkey do." In my talks about financial crisis over the last decades, I have polished one line that always gets a nervous laugh:

There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich...

Update: Rajiv's response (in comments):

...I understand the logic of your first point (which you made in your 1990 JPE paper with SSW) but I'm not sure it applies in the case of the risks taken by BP and AIG, which is what my post was concerned with. You could make the case that even with bankruptcy, the cumulative dividend payouts resulted in higher average returns, or that a portfolio of such firms would have beaten the market on a risk-adjusted basis, but the claim seems empirically dubious to me. The Kindeberger quote is wonderful, but the claim is about interdependent preferences, not cognitive limitations. I don't doubt that cognitive limitations matter (I started my post with the winner's curse after all) but I was trying to shift the focus to interactions and away from psychology. In general I think that the Minsky story can be told with very modest departures from rationality, which to me is one of the strengths of the approach.