Interesting article from Tyler Cowen, one of the bloggers I regularly follow.
In this article he talks about the work of Fischer Black and the wisdom of crowds.
The line of reasoning goes like this: People choose their level of risk, higher risk will justify higher reward. It is assumed that things will not go bad all at once, the law of large numbers will mean that some sectors of the economy, or some regions of the world will do better and some will do worse. Mistakes will occur but they will balance each other out if the portfolio is diversified enough. This assumption is false if all the elements are correlated with each other.
A big pool of loans can be riskier than a single loan. The risk appetite of investors can be habituated such that people get used to risk and are unaware of the possibility of loss.
Risks were intensified because of leverage. Leverage was needed to keep "profits" in line with what everyone else was doing.
Investors systematically overestimated how much they could trust the judgment of other investors. Investment banks overestimated how much they could trust the judgment of other investment banks. Purchasers of mortgage-backed securities overestimated how much they could trust the judgment of both the market and the rating agencies as to the securities’ values.
The law of large numbers makes intuitive sense. Don't put all your eggs in one basket. However, don't leverage your egg 40 to 1, purchase a small slice of many different egg baskets, and buy insurance against the possibility of these baskets being ruined.
Mark Twain put it best: put all your eggs in one basket, and WATCH THAT BASKET. Do not trust other people to watch the basket for you.
Or, just wait for a basket bailout.
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