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

ANDREW LO: Well, for one thing, the financial investments that we make, we need to be aware of what the kinds of risk profiles they have from the very start.

CONSUELO MACK: Such as...

ANDREW LO: Well, such as the maximum volatility that they’ve experienced over the course of the last five years. Typically, investments will have volatilities that are relatively stable during normal times, but during abnormal times, how do they behave? Certain investments like emerging markets can have tremendous losses during those abnormal times, and we need to know that, and we need to be able to factor that in to the investments that we make.

CONSUELO MACK: You mentioned that the S&P 500, for instance, had an 84% annual volatility in 2008. What do I do with that information? Do I say, “All right, I don’t want to expose myself to 84% annual volatility?” So does that mean that I should have my exposure to equities much smaller than I would normally have had in more placid times?

ANDREW LO: One is that it may mean cutting back on your equity exposure, but of course, the problem with that is that if you put your money in bonds, you’re going to be lowering your average returns, and that may not be enough for you to retire on. The other possibility is to take some of that allocation to equities and put it in a more tightly risk-controlled kind of an investment, one where the volatilities are adjusted a little bit more frequently, rebalanced a little bit more actively to manage the risks and diversified a little bit more broadly so that you may be invested in other markets that don’t have the same characteristics as your stock portfolio. So thinking a little bit more broadly and being more concerned and then frankly talking to your financial advisor and demanding more from your financial advisor for these kinds of products, I think, is probably the right answer now.

CONSUELO MACK: Tell us some of the strategies that you’re using to limit the volatility in your three funds.

ANDREW LO: Our funds make use of futures contracts which are very, very liquid investment vehicles that allow us to adjust the exposures relatively quickly and dynamically. So we use a mechanism that we call volatility cruise control, and it does exactly what cruise control in your car does. When your car is going downhill on the highway, the cruise control senses that and reduces the amount of gas, puts on the brakes in order to get that 65 mile an hour speed. When your car is going uphill on the highway, your car senses that and puts on the gas, reduces the brakes so that you stay at that 65 miles per hour.

CONSUELO MACK: So what does that in the portfolio? What increases the speed and what decreases the decline?

ANDREW LO: So in our portfolio, we monitor the volatility on a relatively short-term basis. When we see the volatility of underlying markets begin to increase, we will reduce the exposures to those markets by eliminating futures contracts from the portfolio. Similarly, when we see the volatility coming back down to normal levels, we detect that, and we’ll increase our exposures back to the typical levels, and we do this on a daily basis, and really daily is the key. It’s because volatility changes so rapidly that unless you start managing your risks on a more frequent basis, you’re likely to be closing the barn door after the horses are gone, and so we find that that volatility cruise control ends up allowing us to control the volatility overall reasonably well.

CONSUELO MACK: Now one of the things that I know that you believe in is that you should pay a tremendous amount to your downside potential; that that’s something that can hurt you much more over the long run than the upside potential of your investments. So it sounds like a very risk-averse approach that you’re trying to incorporate into your funds.

ANDREW LO: Well, certainly downside risk is an important aspect to any portfolio that one needs to manage, again, rather actively. So we pay attention to that as well. We have stop-loss control policies that measure the downside losses, and when they reach a certain level, we’ll reduce our exposures to those markets in order to try to preserve a few of the horses before they all leave the barn. And so the idea behind the stop-loss policy is to capture that downside risk. The way stop-loss policies are implemented is important, though, because obviously if you stop your losses, you’re also stopping your gains when the markets recover. So one has to be careful in making sure that you also have a mechanism for getting back in the market as opposed to allowing yourselves the discretion to get back in.
One of the things about human emotion is that we react very quickly when it comes to pain, and we act relatively slowly when it comes to pleasure, meaning that when a market event occurs, we’ll want to get out, but we may not get back in until much later, and that delay can actually be quite costly from the point of view of long-term investing.

CONSUELO MACK: One of the things that we always ask our guests on WealthTrack is if there’s one investment that we should make in a long-term diversified portfolio, what is it? And you chose actually to make a decision to spend time with your family when you’re older. Correct?

ANDREW LO: Right. You know, the whole spirit of the adaptive markets hypothesis is that there isn’t one single investment that would be appropriate at all points in time, because markets are changing. So rather than giving advice about what an investment would be right now that would be most appropriate, I think a better piece of advice would be what kind of investment could one make that would pay dividends for years to come, and I think it’s investing in having conversations with our family members about our finances.
Finance can be boring to many people that are not in the field. I find it fascinating, so it’s hard for me to believe that people find it boring, but nevertheless, there is a significant investment that one needs to make in learning about finances and talking to our loved ones about our finances, but I think the earlier that happens, the better for all parties concerned, because it will reduce the possibility of surprise and it’ll provide additional support that will become really necessary as we get older and begin the transition of decision making and transferring wealth from one generation to the next.

CONSUELO MACK: The financial models failed us during the financial crisis, and you wrote a paper called “Physics Envy May Be Hazardous to Your Wealth.” What’s the problem with the current models, and what relation do they have to physics, and how do they need to change?

ANDREW LO: The physical world has been stable for the last 13 billion years. Financial markets have only been in existence for a few thousand, and so we need to understand that the principles that govern human interactions are markedly different from those that govern physical objects. They change. They’re a function of various different kinds of conditions including emotion. I think Richard Feynman, the physicist, said it best when he said, “Imagine how much harder physics would be if electrons had feelings,” and I think that summarizes this physics envy notion. We can’t look at markets as static mathematical objects any longer. Mathematics will continue to play an important role, but their role is limited, and we need to factor in the human element in those analyses.

CONSUELO MACK: And that’s what you’re doing in your work, no question about it. Financial regulation. Why is that going to change the dynamics of the marketplace?

ANDREW LO: Well, you know, one of the biggest uncertainties hanging over markets is uncertainty about the regulatory landscape. It’s very hard to conduct business if you don’t know what the rules are going to be, and we just passed landmark legislation for financial reform. The financial reform bill was 2,319 pages long, and I don’t think anybody really fully understands what’s in it, but even those who drafted it and know what the words are, they don’t know what the implications are, because none of these rules have actually gotten implemented, and until they get implemented and we develop experience with these rules, the financial landscape will continue to be uncertain, and so I think this is one of the biggest drivers of this volatility roller coaster ride and why I think that over the next couple of years, we’re still likely to see more volatility spikes as we work out the implications of this reform bill.

CONSUELO MACK: And on that happy note, Andrew Lo, thank you so much Professor Lo, for joining us on Wealth Track. We really appreciate it.

ANDREW LO: Thank you for having me. It’s been a pleasure.

CONSUELO MACK: Professor Andrew Lo, a Financial Thought Leader well worth following.

We hope you can join us next week. We are going to revisit our interview with great investor Bill Miller, Legg Mason’s legendary value manager. His Legg Mason Value Trust staged a stunning comeback in 2009 from its precipitous fall from grace during the financial crisis. And if you have missed any of our Great Investor or Financial Thought Leader interviews, you can always catch them on our website, wealthtrack.com as streaming video or a podcast. Until next time, have a great weekend and make the week ahead a profitable and productive one.

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