Liquidity solutions, ‘risk’ accounting, transparency turned into competitive advantage—leading economist Andrew Lo argues that this crisis offers opportunities that are unique.
As we sift though the debris of today’s crisis, economists and policy makers alike are trying to assess why risk management systems and regulatory constraints didn’t kick in before the global economy became engulfed in a tsunami of red ink. But economist Andrew W. Lo, the Harris & Harris Group Professor at MIT’s Sloan School of Management, director of the school’s Laboratory of Financial Engineering and founder and chief scientific officer of AlphaSimplex Group LLC, an investment adviser in Cambridge, Massachusetts, is less surprised than most seasoned observers. Lo has studied the connections between financial decision making, neuroscience and evolutionary psychology for over a decade. Among his findings are that professional traders, far from being cool-headed and rational, can become transfixed by extreme price movements, their decision-making capabilities temporarily hijacked by emotions such as fear and anxiety. In Lo’s view, “behavioral blind spots” (which he defines as evolutionarily hard-wired reactions to perceived risks and rewards) are particularly dangerous during periods of economic extreme: bubbles and crashes. During these times, he says, “market forces cannot be trusted to yield the most sensible outcomes.”
In an interview with SMR editors, Lo says that balance sheets and income statements are adequate for
measuring a company’s profits and losses, but provide no information about future risk. He discusses a number of topics relevant to the financial crisis, including the inadequacies of corporate governance, the weakness of standard accounting practices to assess corporate risk and the need for better information and frameworks to inform risk-based decisions. In Lo’s view, the financial crisis of 2008-2009 has tested two core ideas: the belief that corporate governance systems are designed to maximize shareholder wealth, and the assumption that markets and businesses will always react rationally to environmental change. If the latter were true, he says, Bear Stearns, Lehman Brothers and other financial institutions would have seen different outcomes.
2 Comments On: The Opportunities Brought to You By Distress
An investment manager in a fund devoted to a specific asset class cannot suggest parking the portfolio in T bills for a year or so or he’ll be told “Sonny, we don’t need you for that. Find suitable assets in your class or go away.” But there are no assets in the class which are safe at some point. Where is that point? I remember an old adage about the laws of thermodynamics and entropy: “You can’t win, you can’t break even, and you can’t get out of the game.” The investment manager’s dilemma. But when stock valuations get to the discounting the hereafter level, it’s time to leave even if it gets you criticized for passing up further growth.
David L. Wiesen ’54
As we sift though the debris of today’s crisis, economists and policy makers alike are trying to assess why risk management systems and regulatory constraints didn’t kick in before the global economy became engulfed in a tsunami of red ink. But economist Andrew W. Lo, the Harris & Harris Group Professor at MIT’s Sloan School of Management, director of the school’s Laboratory of Financial Engineering and founder and chief scientific officer of AlphaSimplex Group LLC, an investment adviser in Cambridge, Massachusetts, is less surprised than most seasoned observers. Lo has studied the connections between financial decision making, neuroscience and evolutionary psychology for over a decade. Among his findings are that professional traders, far from being cool-headed and rational, can become transfixed by extreme price movements, their decision-making capabilities temporarily hijacked by emotions such as fear and anxiety. In Lo’s view, “behavioral blind spots”(which he defines as evolutionarily hard-wired reactions to perceived risks and rewards) are particularly dangerous during periods of economic extreme: bubbles and crashes.