Endogenous return and risk: Feedback effects on expected returns
• Feedback loops can amplify market movements if market participants respond to past performance. Irrational extrapolation may have evolutionary origins. Virtuous and vicious cycles may also reflect rational forces, such as wealth-dependent risk aversion, leverage cycles, and liquidity spirals.
• Such dynamics are especially powerful when applied to market direction (booms and busts) but they can also be overlaid on the performance of any asset or strategy. Presumably, they contribute to both short-term momentum and long-term reversal patterns observed for many assets.
• Recent success can make any asset or strategy more popular over time and thereby also more risky (beta like), especially when a number of years pass between realization of negative risk events. Crowdedness raises liquidation risks and makes the return stream more negatively skewed. Currency carry strategies and the August 2007 quant crisis are good illustrations.
The 12 case studies above contain limited discussion about market dynamics. However, an important feature of financial market regularities is that market participants tend to respond to past performance, often herding into recently successful strategies. Imitating success, or learning, may have been an evolutionarily useful approach for our ancestors, and thus hardwired into us, but in modern financial markets this tendency may be unhealthy, even dangerous. Such feedback effects make ...