Back when investing was more of a closed ol' boys network, there wasn't a ton of original research going on. When one person got a good idea -- or rather, they got good information from a company or analyst -- it spread around via brokers to their client circles. What emerged was a consensus trade -- large groups of people all investing in the same thing at the same time. Consensus can work in two ways:
- very successful: when the trade works, it makes everyone a lot of money
- bottom drops out and everyone suffers: but when it doesn't, well, it compounds the losses of all involved.
Hedge funds not doing their own original research
In a recent paper, Dangerous Connections: Hedge Funds, Brokers, and the Emergence of a Consensus Trade (here's a version of an older paper), researchers at the London School of Economics found that there were very distinct social networks in place among top hedge fund mangers including analysts, traders, and brokers who service them.
Social networks: amplifying effectOne of the researchers, Yuval Milo described that these interconnections between funds and brokers serves as an "amplifying mechanism":
"They increase the likelihood that a group of hedge funds can all head off in a wrong direction with an investment idea. We found that this is not just a fringe phenomenon. There is enough of it going on to make the market vulnerable."