ANDREW LO: Well, so I think it would be a mistake to withdraw clearly, because obviously when individuals are planning for their retirement, they can’t do that by investing in Treasury bills; but at the same time, I think that they do need to be more cautious, more careful. They need to be more discriminating consumers of investment products. So the short answer is I think investors really have to be more alert in much the same way that we have to be more alert now about what we eat. You know, there’s all sorts of medical information about cholesterol, about carbohydrates. I think we need to become more educated about investments. We have to think about volatility. We have to think about correlation. We have to think about various different asset classes.
I do think it’s possible to put together an attractive portfolio to weather this kind of storm, but I really think that we need to think in those terms. That is, over the next couple of years, there’s going to be some rough seas, and we need to batten down the hatches. We need to make sure that we understand where our risks are, why we’re taking them, how much risk we can withstand, whether or not our portfolios are structured to generate those kinds of risks and to limit the kind of risks that we take on, and then to be able to weather those storms over the course of the next couple of years without panicking. I think that’s really the key. Once we panic, all is lost.
CONSUELO MACK: So that sounds like a tall order for an individual investor, is what you’re kind of expecting us to do, and I know that at AlphaSimplex Group, that you’ve devised three funds that are put out, distributed by Natixis, that have to do with investing in non correlated assets and diversifying the way you think we should diversify. So let’s talk about diversification first of all, and one of the really fun phrases that I remember you using on Wealth Track was that we’ve suffered from diversification deficit disorder. What do you mean by that?
ANDREW LO: Well, you know, what I meant by diversification deficit disorder was the fact that most investors thought they were well-diversified by having their investments in long-only index funds as well as balanced funds and bond funds, and what we found from 2008 was that you could have had your money in all of these funds, and you would have lost across the board. That is an example of diversification deficit disorder. So the idea behind dealing with this diversification disorder is to think about more asset classes, so going beyond stocks and bonds to currencies, commodities, and other kinds of alternative vehicles, and then to do it on a long and short basis, and to do it in a risk-controlled format, so you’re not swinging for the fences, you’re not betting on crazy schemes but really responsibly investing in these broader asset classes in a risk-controlled way.
CONSUELO MACK: As a behavioral economist, is there herd behavior that you’re seeing now that are setting off any alarm bells?
ANDREW LO: Oh, there’s definitely a lot of herd behavior. In fact, one could argue that the kind of volatility roller coaster ride that we’ve seen is largely driven by herd behavior. The fact that Treasuries occasionally have negative yield is another example of herd behavior, and so I think it’s really the crowd that one has to be wary of. We’ve talked often about the wisdom of crowds. Well, the wisdom of crowds makes sense when the crowd is acting wise, when they’re independent and they’re gathering information. But every once in a while, the wisdom of crowds can turn into the madness of mobs, and everybody knows to get out of the way of these mobs, so I think we have to worry about that, and we’re seeing that more often in these markets today.
CONSUELO MACK: So aside from Treasuries, where are you seeing the madness of mobs?
ANDREW LO: Some would argue that we’re seeing it now in gold. Because of concerns of inflation, gold has been driven up very high. Some would argue that emerging market investments are a bit of a madness of mobs, and certainly in cases where we have any kind of rumors about potential problems with a financial firm or an organization, we’re seeing flight to quality happening very, very rapidly.
CONSUELO MACK: So would you argue that there’s madness in the gold market and the emerging markets as well, or what’s your sense of their value levels?
ANDREW LO: So I think there’s danger in those markets in the sense that-- let’s take gold as an example. Gold is at a very high level now, most likely in anticipation for inflation that’s about to occur, but if you look at the various different government bond yields, even the 30-year government bond is trading at maybe 4%. It’s not a sign of great inflation. I don’t know how many viewers remember the time in the 1980s when fixed-rate mortgages were at 18.5%. I mean, that’s inflation. We’re not there yet, and all accounts and all of the market entrails suggest that we’re not likely to have inflation for at least a few years. So in that sense, the price of gold seems awfully high.
CONSUELO MACK: You are a proponent of what you call the adaptive markets hypothesis, and it differs from the efficient market theory which is what most of us were educated on and grew up with. So what is the adaptive markets theory, and why should we care about it, or should we care about it as an individual investor?
