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.
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.
Fear, Greed, and Crisis Management: A Neuroscientific Perspective
The alleged fraud perpetrated by Bernard Madoff is a timely and powerful microcosm of the current economic crisis, and it underscores the origin of all financial bubbles and busts: fear and greed.
Using techniques such as magnetic resonance imaging, neuroscientists have documented the fact that monetary gain stimulates the same reward circuitry as cocaine — in both cases, dopamine is released into the nucleus accumbens. Similarly, the threat of financial loss activates the same fight-or-flight circuitry as physical attacks, releasing adrenaline and cortisol into the bloodstream, which results in elevated heart rate, blood pressure, and alertness.