I really like this bit from Steve Randy Waldman:
I think that there’s a trade-off between microlevel diversification and macro-efficiency. Barry Bosworth warned that “diversification devalues knowledge”. One reason that micro portfolio choices fail to compose is because it is often sensible for investors to “buy the market”. Every individual has a unique information set, and ideally we would want all that decentralized knowledge “priced into the market” independently of the judgments of others. However, each individual knows that her own information is profoundly uncertain and incomplete, and that the market represents an aggregation of the judgments of millions of others. So, as passive-investment types have been telling us for more than a decade, it may be optimal for individuals to ignore their own information and defer to the judgement of the market-ex-me. (This is a kind of “information cascade”.) But, each person who defers to the market increases the concentration of investment decision making, and decreases the breath of information that is priced into the market. If the aggregate portfolio is disproportionately by the decisions of a relatively small group of people, there is no reason to suspect its quality would be better than that decided upon by a bureaucracy of planners. There is reason to suspect, in fact, that it would be worse, because at least the planners know they should at least pretend to serve a broad public interest, while private decisionmakers might quite legitimately think they’re just trying to get a piece of next year’s bonus pool.
In sum, I think there is a tension between micro diversification and macro diversification. If we want to maintain a well-diversified aggregate portfolio, it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk. We might be better off by letting individuals shed risk via some form of social insurance while forcing investment choices to be sharp, than by encouraging people to blur the information they present in their portfolio choices in order to diversify and hedge.