When a bridge over a river collapses, the engineers who built the bridge have to take responsibility. But typically, critics call for improvement and smarter, better-trained engineers—not fewer of them. The same pattern seems to apply to financial engineers. At MIT, the Sloan School of Management is starting a one-year master's in finance this fall because the field has become too complex to be adequately covered as part of a traditional MBA program, and because of student demand. The new finance program, MIT Sloan Prof. Andrew Lo noted, had 179 applicants for 25 places.
The basic principles of asset allocation need to be revised," says MIT finance professor Andrew Lo. He and other experts argue that since market volatility is rising, you must now own other assets—such as hedge-fund-like investments—in addition to stocks and bonds to manage risk. And you must be prepared to shift your mix tactically from time to time. "You need to be proactive and adjust as the market changes."
In this letter to the editor, MIT Sloan Prof. Henry Birdseye Weil says that MIT Sloan Prof. Andrew Lo's article, 'Why animal spirits can cause markets to break down,' makes "an extremely important point. Models that assume, at least implicitly, that decisions-makers understand the structure of the market and how it produces the dynamics that can be observed or might potentially occur can be dangerous simplifications and seriously miselading."
One economist leading the effort to define the new paradigm is Andrew Lo, of the Massachusetts Institute of Technology, who sees merit in both the rational and behavioural views. He has tried to reconcile them in the "adaptive markets hypothesis," which supposes that humans are neither fully rational nor psychologically unhinged. Instead, they work by making best guesses and by trial and error. If one investment strategy fails, they try another.
Andrew W. Lo, a finance professor at MIT, enjoys a setup that many other academics would envy: tenure at a top university, opportunities to earn extra money through consulting, and acclaim for his research. That's not enough for Dr. Lo. He wants to show the world that his theories and computations can generate profits to investors. "If you go into finance instead of math, you're interested in having an impact," he says.
MIT Sloan Prof. Andrew Lo says, "Everyone lost out last year due to the tremendous volatility in markets. But the typical retail investor is left to their own devices in managing disloction, and some product innovation is needed to help with this."