When Crowded Trades
Become Bubbles

November 2018

“There is nothing so disastrous as a rational investment policy in an irrational world.”

This quotation, attributed to John Maynard Keynes, highlights the challenge of maintaining investment discipline in a world where financial bubbles can inflate for years before they finally burst. If investors can locate a bubble sufficiently early they can profit from the run up in prices. But in order to profit from a bubble investors must exit the bubble before the selloff erodes all of the profits. We propose two measures for managing exposure to bubbles. One measure, called asset centrality, locates crowded trading which often leads to the formation of bubbles. The other is a measure of relative value, which helps to separate inflationary crowding from deflationary crowding. Neither measure by itself is sufficient for identifying the full cycle of a bubble, but we show that together these measures have the potential to locate bubbles as they begin to emerge and to identify exit points before they fully deflate.

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