MIT's Andy Lo: Markets are Adaptive, Not Efficient

WealthTrack's Connie Mack interviewed MIT's Andy Lo. Here for your review are the video and transcript. Lo discusses his 'Adaptive Market Hypothesis' which in a nutshell, challenges Modern Portfolio Theory's 'Efficient Market Hypothesis.' Lo contends that markets are not efficient, but rather adaptive.

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CONSUELO MACK: This week on WealthTrack: fasten your seat belts. Our Financial Thought Leader, alternative investment manager and MIT professor Andrew Lo, says the market’s volatility and uncertainty is here to stay. Strategies for riding the financial roller coaster are next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Do you feel that the financial markets are more unpredictable and arbitrary than ever? Well it is not your imagination! Unless you lived during the Roaring Twenties and the Depression-era thirties, you have never seen anything like it, until now.

Take a look at this chart provided to us by this week’s Financial Thought Leader guest. It shows the historical volatility of a broad-based stock market index from 1926 to the present. Notice the wide and wild swings at the beginning, the twenties and thirties, followed by the relative calm for the decades in between- the historical average of market volatility is 14.5%- and then the astonishing pick up in market volatility during the last couple of years. This week’s guest says “fasten your seatbelts,” the roller coaster ride will continue.

One of the true treats of WealthTrack is our ability to talk to some of the most creative and original thinkers in the investment world. And today’s guest is right up there with the best of them. This week’s Financial Thought Leader is Andrew Lo, PhD economist, professor of finance at the MIT Sloan School of Management, director of MIT’s Laboratory for Financial Engineering, and author of numerous articles and several books, including A Non-Random Walk Down Wall Street . Professor Lo also puts his ideas to work as an investor. He is the founder and chief scientific officer of AlphaSimplex Group, an investment firm whose slogan is “adaptive strategies for evolving markets.” In recent years, the firm has introduced several mutual funds under the name of its parent company Natixis, which are designed to help investors protect themselves in these ever evolving markets by limiting their portfolio risk and volatility. We will provide a link on our website, wealthtrack.com.
I asked Professor Lo to talk about some of the biggest changes he sees in the markets, starting with what he calls internet time.

ANDREW LO: We are living in Internet time now, and I mean that not just as an analogy but literally in the sense that, because of the Internet, information is transmitted at lightning speed, whereas before it would take weeks or months for certain kinds of news to get out. Nowadays it’s reflected almost instantaneously and this has dramatic implications in how financial markets operate and how we react to those kinds of surprises. Over the last two or three years, I think we’ve been on this volatility roller coaster ride where traditional investments that offered relatively traditional kinds of risks are now really unpredictable in the kind of volatility that they provide to investors.

CONSUELO MACK: Such as which kind of investment? Stocks and bonds?

ANDREW LO: Well, yeah, for example, let’s take stocks. You know, the S&P 500 traditionally has had a volatility of around 15% per year. Well, during the fourth quarter of 2008, the volatility reached as high as 85%. At 85% annual volatility, there’s a good chance that an investor can lose all their investment over the course of a few days. I don’t think anybody could withstand that kind of a risk. Fortunately it doesn’t last very long, but for the periods where volatility spikes, it’s tremendously disruptive for investors. And that’s really a relatively new phenomenon.

CONSUELO MACK: So when you say it’s a new phenomenon- now there’s a sentiment on Wall Street, in fact, that the kind of volatility that you just alluded to in 2008, 2009, that that’s over and essentially that we’re back to a normalcy that we’ve had for the last 40 or so years. You’re not sure that’s the case though, right?

ANDREW LO: No, I’m not. I think that it is over until it’s not, and so a good example of this is what happened in the beginning of this year. It looked like we were heading to calmer waters. It looked like the market was recovering. Certainly, last year was a good year for the stock market, and things were going pretty well until April and May, and what happened then was Greece. Now, certainly people knew that Greece had a debt problem even as early as, you know, three or four years ago, but it didn’t become a public problem until April and May. And during that period of time, the market volatility spiked yet again, and so next year it may not be Greece. It may be Spain. It may be Portugal. It may be emerging market debt. It may be gold. It may be something that will cause the public to fly to quality and safety.

CONSUELO MACK: i.e., Treasuries.

ANDREW LO: That’s right.

CONSUELO MACK: Which they’ve been doing.

ANDREW LO: And in fact, Treasuries have been remarkably volatile themselves in terms of the money flowing in and out. In fact, as we know, Treasuries have had negative yield for periods of time over the last couple of years. I mean, negative yield is a remarkable phenomenon. It basically says that I’m willing to lose money over the course of the next three months in order to put my money in U.S. Treasury securities, and that’s a sign that there is genuine fear in the marketplace. When you have this kind of fear, markets are very unpredictable and moreover, the volatility of volatility becomes an important factor.

CONSUELO MACK: Listening to you, I’m getting terrified.

ANDREW LO: I’m sorry.

CONSUELO MACK: Essentially, but here you are. You’re a PhD economist, and you are a behavioral economist as well as a risk management expert. So if uncertainty like that you’ve just described is going to be part of our life for the foreseeable future- correct? Then how do we deal with the risks of uncertainty as individual investors? What can we do to protect ourselves, aside from withdraw from the markets?