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."
The push for financial regulatory reform has highlighted an important debate surrounding the Efficient Markets Hypothesis, the idea that market prices are rationally determined and fully reflect all available information. If true, the EMH implies that regulation is largely unnecessary because markets allocate resources and risks efficiently via the "invisible hand". However, critics of the EMH argue that human behaviour is hardly rational but is driven by "animal spirits" that generate market bubbles and busts, and regulation is essential for reining in misbehavior.
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."
Some people are blaming the economic crisis on financial engineering and business school education. Similar to how the 1986 space shuttle disaster cannot be blamed on aerospace engineering, it is inaccurate to blame the crisis on technical know-how. Rather, the misuse of technology and poor judgment are to blame. Initial evidence about the current crisis suggests that executives at financial institutions did not deem risk assessments to be important. This suggests a lack of judgment, understanding, and training. As financial markets become more complex, it is becoming harder for conventional, two-year MBA programs to sufficiently train MBA candidates. But education beyond this level typically gets no support from the federal government, unlike other engineering fields. The Sloan School of Management at the Massachusetts of Institute of Technology awarded only four PhDs in finance in 2007, similar to other top business schools. To foster greater expertise, it is important to offer scholarships in financial engineering that could be paid for by a small
tax on derivatives transactions. By sufficiently training future leaders to handle financial system risks, it will become easier to withstand financial crises.
Dealing with the new market realities. Two giants of behavioral finance, Yale Professor and "Irrational Exuberance" author Robert Shiller and MIT professor and hedge fund manager Andrew Lo, discuss where the money will be made in the new financial landscape.