How many of us waited in long food lines at the supermarket in early March as the world came to grips with the coronavirus pandemic’s global spread? Why were you waiting in those food lines? You want food, other people want food. There very likely is enough food for everyone, but do people trust that others will behave rationally and show restraint to buy only what they need, or are they fearful that others may look to hoard as much as possible? What are the parallels to financial panics like the one we have been experiencing?
Mike Nigro, Two Sigma’s Head of Client Solutions Research (the group that is also responsible for the research and methodologies applied in Venn), and David Cohen, Two Sigma’s Global Head of Investor Relations, recently published “Unwinds, Diversification, and Constraints: The Mechanics of Financial Panics.”
In summary, the authors unpack the mechanics of financial panics. They outline two concepts that contribute to panics: constraints and diversification. Constraints are limitations or restrictions that may get in the way of otherwise optimal choices. Examples of constraints include leverage and liquidity. Diversification means that problems in one area of the market can adversely affect other seemingly unrelated markets. When combined in a multi-player setting, both constraints and diversification can turn formerly unrelated markets into interconnected panic zones. It is important for both asset managers and asset owners to better understand these mechanics in order to build context for why performance can be outside typical expectations during panic episodes.
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