More money chasing less investment opportunities creates crowded trades, a buzzword increasingly used in the modern market. It is also a sign of potential volatility. An idea that once attracted $500 million now attracts $1 billion. A $1 billion trade may attract $5 billion. This money is invested in stocks, bonds, and derivatives. The money may stay put for a few days, months, or years. When the money exits the opportunity, volatility often follows. These crowded trades suggest major investors increasingly lack original thought. This is not insignificant. It may encourage perverse behaviors that harm many people.
In 2005, when Raghuram G. Rajan was the International Monetary Fund’s chief economist, he penned a paper raising concerns that revolutionary changes to the financial system since 1975, including technology and the creation of complicated financial products, were making the world riskier. Rajan was mostly denounced, but he was vindicated two years later when the subprime credit crisis began in the United States in 2007 and soon engulfed the world financial markets. Rajan, who is now a professor at the University of Chicago’s business school, was concerned that it was easy to induce “a variety of perverse behavior” among investment managers. Herein lies the perversity:
The knowledge that managers are being evaluated against others can induce superior performance, but also a variety of perverse behavior. One is to take risk that is concealed from investors—since ...