The Opportunities Brought to You By Distress

Liquidity solutions, ‘risk’ accounting, transparency turned into competitive advantage—leading economist Andrew Lo argues that this crisis offers opportunities that are unique.

“Bubbles” are old. Variations on the most legendary one, Holland’s tulip craze of the 1630s, have recurred time and again. In the past decade alone, we’ve experienced the “dot-com” boom and bust, only to be followed by the current financial meltdown triggered by the decline in U.S. housing prices and reduced credit. Now, sifting through 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 red ink. Executives are trying to assess what the whole business means for how to run their companies. And nearly everyone is trying to get over the shock.

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But Andrew W. Lo is a lot less surprised than most seasoned observers. As 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, Lo has been studying the connections between financial decision making, neuroscience and evolutionary psychology for over a decade. His ideas about the role of human behavior in the financial markets have recently attracted the attention of policy-makers in Washington, who in addition to sorting out what led to the current crisis want to learn how to head off future destructive events.

The leading question

Why didn’t risk management systems and regulatory constraints kick in before the global economy collapsed?

Findings
  • During bubbles and crashes, professional traders get swept away by emotions such as fear and anxiety.
  • Many corporations did a terrible job of assessing and managing their risk exposures.
  • Companies need to change the way they discuss and debate corporate strategy and how they measure and manage risk.

Testifying before the House Committee on Oversight and Government Reform last November, Lo pointed out that credit crises have been regular occurrences over the past 35 years and that typically they are resolved without regulatory interventions. “Financial crises are an unfortunate but necessary consequence of modern capitalism,” he explained.

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2 Comments On: The Opportunities Brought to You By Distress

  • dwiesen | April 4, 2009

    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

  • Ellen Gracie | October 31, 2011

    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.

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