March 2016 10 Questions

Andrew Lo on Volatility, Trend Following, and Why Traditional Financial Advice Is Incomplete

Journal of Financial Planning: March 2016



WHO: Andrew Lo, Ph.D.

WHAT: Professor of finance, and director of the Laboratory for Financial Engineering at the MIT Sloan School of Management

WHAT'S ON HIS MIND:  “Rather than expecting investors to do the superhuman, what I think we need to do is to give better advice and develop better products.”

For any teacher, effecting change—in your students, in the world—is perhaps your ultimate goal. And MIT professor Andrew Lo is doing exactly that. A leading thinker and researcher on the psychology of investors, Lo is trying to change the way students, and ultimately financial planners and consumers, think about the market and how we, as humans, make financial decisions.

Not satisfied that many students are still learning about finance through a framework that Lo calls deterministic and mechanistic, he’s teaching a new elective on financial market dynamics and human behavior, where he’ll be bringing some of the latest behavioral finance research into the classroom.

We’re talking about a paradigm shift here: from thinking about the market as a “kind of machine,” as Lo tells us, to thinking about it more like “a very complicated ecology with different flora and fauna” where we’re not the only species.

The Journal recently sat down with Lo to learn more about this shift in mindset from the market as a physical system to a biological one, as well as his thoughts on adaptive markets, the economic outlook for 2016, and even curing cancer.

1. You are the director of the Laboratory for Financial Engineering at the MIT Sloan School of Management. What research has come out of the lab during your tenure that you are most proud of?

That’s sort of like asking who your favorite child is, but I think there are three things I’m most proud of. One is the research that I’ve done on the Adaptive Markets Hypothesis. This is a new view of financial markets that looks at economic interactions through the lens of evolutionary biology to try to understand how it could be that markets can be so important and work so well at times and fail us so badly at other times.

The second thing that I’m most proud of is the work I’ve done on the financial crisis, specifically around quantifying systemic risk, developing methods for managing it, and the policy work that’s come out of it.

And the third is the most recent work I’ve been doing on thinking about creative ways to fund biomedical innovation, particularly cancer research and drug development.

2. What research projects are you working on now that may be of particular interest to financial planners?

There’s actually a fairly big research project that we're just launching that would be of direct relevance to financial planners, involving the modeling of human behavior in investing.

One of the things we’ve realized over the years is that there are lots of proposals that financial economists and financial planners have made for how investors ought to behave, but there’s very little attention being paid on how investors actually do behave. And what we’re trying to do now is develop a deeper understanding—and ultimately an algorithmic representation of investor behavior—of the psychology of investors as they engage in financial decision-making.

Once we are able to construct accurate algorithms that capture how investors actually make their decisions, we can then start to develop better financial products and services to address some of the less productive elements of those behaviors.

One of my students informally called this product “artificial stupidity,” as opposed to artificial intelligence. I told him it was a little unkind because investors aren’t just being stupid, they’re being human, so “artificial humanity” is probably a better word for it, but not quite as catchy.

3. Some folks have been sounding the alarm recently—that 2016 may be the toughest year for the global economy since the financial crisis. Do you agree? How do you feel about the economy, and what do you think will happen with the stock market, in particular, going into 2016?

You know, embedded in that are two questions—how do I feel and what do I think. I may feel very uncomfortable and queasy, but what do I think? I think that markets are going to go up and down over the course of the year. There’s going to be a roller-coaster ride because of what’s happening in China, what’s happening with oil, what’s going on with the Middle East.

There are all sorts of macro events that are going to create market volatility, and the volatility of volatility is going to be pretty high. But ultimately, what we want to be aware of is that in the longer run—and by the longer run I’m talking five years, 10 years—the market’s prospects, particularly in the United States, are very promising. I think that if we are able to think rationally about the markets, we would be invested in equities and be able to manage through the volatility over the course of the next year or so.

But I think the challenge that investors and financial planners are going to be dealing with is what I call the “freak-out factor.” When markets go up and down, particularly when it’s an extreme roller-coaster ride, investors are bound to freak out. And the challenge for financial planners is basically to help investors get through that period without too much damage. And so it may mean ultimately trimming back their equity exposures so that the volatility is not going to be as damaging to their portfolios—and more importantly to their psyches—but I think that eventually these kinds of gyrations will subside and we’ll reach a new normal where investors are going to be able to benefit from the long-run equity risk premium that they have in the past.

4. You have written and talked about how financial engineering can play a major role in curing cancer by creating a multi-billion dollar cancer mega-fund that would invest in a hundred or more projects at once. What’s the latest on this?

I’m glad to say that this crazy idea seems to be getting less crazy day by day. And I think part of it is because there’s a real need in the industry. The pharmaceutical companies are being challenged by investors, shareholders, activists, as well as the patent cliff and other economic realities that they, and all the rest of us, are having to grapple with. So I think that the time is ripe for disruptive innovation in how we fund the drug development process.

A few things going on at the very small end of the spectrum for addressing rare diseases, diseases like ALS, or muscular dystrophy, or hemophilia, are moving very rapidly from a scientific perspective. Most recently, a company called BridgeBio Capital, which I’ve been advising and in which I’ve made a small seed investment, just got funded and will be launching within the next few weeks to be able to invest in rare diseases. So that’s very promising.

On a much larger scale, President Obama announced the "cancer moonshot," which should be the beginning of many billions of dollars devoted to treating and, eventually, curing cancer. I expect several cancer-related initiatives to be launched within the next few months, a number of them with novel financing structures and investors. 

It may take us a while to get up to that $30 billion number I think we will eventually reach, but it’s the same way that the mortgage-backed securities industry got started and how many other asset-based securities businesses emerged. You begin with a few examples, and once you see two or three of them working, all of a sudden you get a huge inflow of capital and the industry takes off.

5. You are also founder and chief investment strategist at AlphaSimplex, an investment research and management company, where your Adaptive Markets Hypothesis is the basis of the company’s investment strategies. How does the misalignment between investor perception and market reality—which can cause investor expectations and experience to deviate sharply at times—also create opportunities to create value for investors?

One concrete example is a managed futures strategy that’s one of several mutual funds we offer. The idea behind a managed futures strategy is that you’re going to be following trends. So if the price of oil goes down, then you tend to sell it. If the price of cocoa goes up, then you tend to buy it as a trend follower.

Trend following is certainly not new, it’s been around for decades now. So you might ask, well, why does it persist? If everybody wants to follow trends, then doesn’t that cause trends to disappear? And the answer is no, it doesn’t, because there is something fundamental about how trends get created—it’s basically part of investor psychology.

Investors are not comfortable buying something unless they think they’re getting reasonable value. And how they determine whether or not they’re getting reasonable value is partly from fundamental analysis, but part of it is also price momentum. If they see a product going up in value, that actually makes it more attractive, not less, because they’re thinking about it as an investment, as opposed to a consumption good.

That’s a key difference between investments and other parts of economics. Think about the price of gasoline. If gasoline goes up by $3 a gallon, you’re probably going to drive around a lot less. You’re probably going to buy smaller cars and stay away from SUVs, and vice-versa if the price of gasoline goes down. But gasoline is not an investment good; it’s a commodity that you consume. If you think about an investment, the more an investment goes up, the more you think it’s got prospects of going up even farther. A classic example is modern art. You can buy a painting for $100, but if I tell you that this painting actually sells for $10,000, but it was $5,000 last year, that will make you want it even more.

So that’s an example of why trend following works—it works because people actually respond to trends and continue to buy as prices are going up. It doesn’t work forever, and trends certainly break and reverse, so it’s not a fool-proof strategy, but it’s something that is persistent and part of human psychology, and therefore, trend-following strategies are going to benefit from that over time and be able to earn a reasonable expected return for investors given the level of risk that’s involved.

6. You proposed the Adaptive Markets Hypothesis (AMH) more than 10 years ago. This is a framework for understanding financial market dynamics that reconciles Efficient Market Theory with behavioral finance anomalies. Where are we today? Have there been any advancements in cognitive neurosciences research that have changed AMH?

There have been plenty of developments, which I think are quite encouraging. You know, the Adaptive Markets Hypothesis was formulated well before the financial crisis. At that time, behavioral finance was still viewed as kind of a scandelous academic pursuit that respectable financial academics would not get involved in. And that’s changed; economists now acknowledged that behavior does matter, and people aren’t rational all the time.

The problem is that the behavioral finance literature hasn’t offered an alternative to efficient markets. And as we all know, it takes a theory to beat a theory, and behavioral finance is not yet a theory.

Over the course of the last decade, there’s been progress on a number of fronts. First, the neuroscientific literature has actually produced lots more evidence of what the origin of behavior is at the physiological level. The fact that we are wired differently for different circumstances leads us to understand now what the ultimate origins are of emotional versus logical deliberation. So we now have a neuroscientific underpinning for adaptive markets.

And then the mathematical theories that my co-authors and I have developed over the last few years have sort of fleshed out how adaptation occurs. We’re now starting to do empirical analysis to document these kinds of adaptations. And the hedge fund industry is the Galapagos Islands of the financial world in that respect. You can see evolution occurring literally year by year in that industry. That’s probably the best illustration of strategies waxing, waning, adapting, innovating, mutating in a way that can actually be understood and even predicted by the theory of adaptive markets.

7. What do you feel is the biggest misperception people, including financial planners, have about financial markets?

Probably the biggest misconception is that it is a monolithic, physical system that has immutable laws that can be understood and relied upon to work consistently through time. I think that’s probably the most difficult concept to get around, and I think partly it’s because we generally think of the market as kind of a machine that’s got certain mechanical elements that we can divine and then be able to exploit in certain ways.

In fact, the market is more like a very complicated ecology with different flora and fauna. And we have to remember that we’re not the only species in that ecology, so when we act in certain ways, there are going to be consequences across the various different parts of the ecosystem. So just changing that paradigm from a physical system to a biological system, I think, is really the greatest challenge that people—including financial planners—have in thinking about financial markets.

8. Your working paper on SSRN called “What Is an Index?” proposes that the traditional advice of “equities in the long run” and “buy and hold” may not be as effective in today’s environment of seesawing volatility and intense financial innovation. In your opinion, what should the “new” advice be?

First, just to be clear, the traditional advice isn’t wrong, it’s just incomplete. The reason it’s incomplete is because it doesn’t take into account the so-called freak-out factor. It is a good idea to hold investments, particularly equity investments for the long run, however you’ve got to make sure that the short run doesn’t kill you first.

I mean, that’s the piece that’s missing from financial advice. We often criticize investors for not holding on to their investments through thick and thin, for not being "long-term investors." But no rational investor would willingly sit by and watch his or her investment decline by over 50 percent without doing anything. And yet, that’s exactly what an S&P 500 fund would have done between 2008 and 2009. And I think it’s unreasonable, it’s unrealistic to expect an investor to buy and hold and leave that portfolio untouched while half of the retirement assets evaporate.

Rather than expecting investors to do the superhuman, what I think we need to do is to give better advice and develop better products. We need to reduce the exposures of their portfolios as they are losing money. Most importantly, we need to put back those exposures after a pre-specified period of time.

Investors are actually not stupid in getting out when the market is going down. Because typically when the market goes down, it can go down for a while, and so getting out of the market when there’s a crash is not necessarily a terrible thing. What makes it a terrible thing is that investors wait far too long to get back in. I think that imposing some discipline about when to get out and when to get back in, and to be able to manage your risk so you are not going to be faced with too many freak-out moments in your portfolio is really the key.

All of the advice that we’ve been getting from financial planners, it’s not bad advice, but it needs to be supplemented by some recognition that humans are going to react in certain predictable ways when markets start to dislocate, and we need to plan for those dislocations.

9. You recently co-authored the opinion piece, “A New Approach to Financial Regulation,” with Simon Levin in the Proceedings of the National Academy of Sciences. What can we learn from biological systems in designing new regulatory frameworks for financial systems?

That’s been a really interesting collaboration and it’s related to two of the ideas that I described as my being most proud of. Obviously, the financial crisis was a terrible event that we economists really should be doing a lot more about. One of the insights from the Adaptive Markets perspective is that we’re thinking about financial crises all wrong, and policymakers and regulators are falling into the same trap.

In particular, regulators are thinking about the financial system as a mechanistic, physical system. Therefore, if they simply impose enough rules to guard the system against going off in certain unproductive directions, that will be enough. The fact is, the system is a highly adaptive organic system, and as you impose these rules, the participants are going to change their behavior to be able to get around those rules.

In speaking with evolutionary biologists and ecologists like Simon Levin, it became clear to me that they were thinking about systems in a dramatically different way than we were.

When an ecologist is asked to help manage a particular ecology, like a modern fishery, or a particular farm, they think not just about the particular plants or animals that they’re raising, but about the entire ecosystem. They think about the bacteria in the soil, or the potential natural predators, or the sources of food. They think about the whole system as a system. And I think that’s what we’re missing now when we think about financial regulation—we don’t think about the system as a system.

If you think about the U.S. financial regulatory system, we’ve got the SEC focused on securities exchanges, mutual funds, and asset managers. We’ve got the CFTC focused on futures and derivatives. We’ve got the FDIC and the Fed focused on banks. All of these different regulatory agencies are focused on specific institutions as opposed to the entire system. And with the financial crisis we did have the Dodd-Frank law that created the Financial Stability Oversight Council, which is a college of financial regulators that get together quarterly to discuss financial stability. But that’s not really an integrated and centralized agency focusing on measuring and managing systemic risk.

So the idea behind the opinion piece was to bring various different stakeholders together to start thinking about financial regulation from a broader perspective. And we held a conference in Washington D.C. in February where we had regulators, evolutionary biologists, ecologists, economists, physicists, interacting with each other, all focusing on different ways of engaging in financial regulatory reform.

10. Your paper, “The Gordon Gekko Effect,” explores the role of culture in the financial industry and proposes a way to change that culture by way of “behavioral risk management.” Can you tell us more about what you’re proposing?

I’m no expert in culture; I have to make that disclaimer upfront. I really got interested in this because I was asked to speak on the topic by the New York Fed. I’m on an advisory board of the Fed called the Financial Advisory Roundtable, and we meet twice a year to talk about aspects of systemic risk and financial stability. And at one of these meetings in October 2014, they asked me to lead a discussion on culture in the financial industry. I know the financial industry, but I hadn’t really thought about culture from an academic perspective. I took it as an invitation to start reading the literature on culture.

There are obviously lots of different angles to consider. Financial ethics is a complicated issue because there are many different stakeholders. We like to chastise the evil bankers and other financiers for their role in the financial crisis, not remembering the fact that there are people employed in that industry as well. The vast majority are honest, hard-working, ethical individuals, and an important few bad apples could really ruin the reputation of the entire industry. We’ve seen this pattern of guilt by association not just in the financial industry, but in other industries as well, like most recently the pharmaceutical industry. Just because one firm’s CEO decides to raise [the cost of] cancer drugs by 5,000 percent, it tarnishes the entire industry, even though the vast majority of people in the bio-pharma space are highly ethical, hard-working, honest people.

The idea behind the paper was to try and provide economists, as well as practitioners, with a bit of an overview about how various academic disciplines think of culture, but then ultimately—since I’m much more of an applied economist, I like to see things put into practice—the question is, what do we do about all of this? We know there are certain behaviors that are unfortunate and unproductive. How do we address these behaviors?

To say that we’re going "change culture" sounds way too idealistic, naïve, and hopelessly impossible. But, if you propose, instead, to engage in "behavioral risk management," now all of a sudden it sounds a lot more focused, actionable, and attainable.

I think that the bottom line of the paper is really a call to arms. We have to start thinking more systematically about these kinds of issues, and start measuring various kinds of cultural features, so we can begin to manage these kinds of behavioral risks.

Carly Schulaka is editor of the Journal. Email her HERE.

The online version of this interview has been updated from the print version for clarity.

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