Understanding Our Blind Spots

An interview with Andrew W. Lo

March 23, 2009

For many business executives, the extent of last fall’s financial meltdown came as a shock. Economist Andrew W. Lo was less surprised. A professor at MIT’s Sloan School of Management, Dr. Lo has studied the connections between financial decision making, neuroscience and evolutionary psychology. In particular, he believes that “behavioral blind spots”—evolutionarily hard-wired reactions to perceived risks and rewards—are particularly dangerous during periods of economic extremes, such as bubbles and crashes.

Testifying before the House Oversight Committee in November, Dr. Lo discussed how credit crises have been regular occurrences over the past 35 years. “Financial crises are an unfortunate but necessary consequence of modern capitalism,” he said. Financial losses, he added, are a byproduct of innovation, “but disruptions and dislocations are greatly magnified when risks have been incorrectly assessed and incorrectly assigned.”

Michael S. Hopkins, Editor in Chief of MIT Sloan Management Review, and Bruce G. Posner, a contributing editor at MIT Sloan Management Review, spoke with Dr. Lo for Business Insight.

Reassess Governance

BUSINESS INSIGHT: What’s the most important implication of the financial crisis?

DR. LO: For CEOs and other corporate leaders, the single most important implication is about the current state of corporate governance. Many corporations did a terrible job in assessing and managing their risk exposures, with some of the most sophisticated companies reporting tens of billions of dollars in losses in a single quarter. How do you lose $40 billion in a quarter and then argue that you’ve properly assessed your risk exposures?

I don’t think it’s credible to say it was just bad luck. If troubled companies want to explain away 2008 as a “black swan,” then someone should take responsibility for creating the oil slick that seems to have tarred the entire flock! The current crisis is a major wake-up call that we need to change corporate governance to be more risk-sensitive.

BUSINESS INSIGHT: What allowed this crisis to happen? How could so many seemingly smart people be so blindsided?

DR LO: The very fact that so many smart and experienced corporate leaders were all led astray suggests that the crisis can’t be blamed on the mistakes of a few greedy CEOs. In my view, there’s something fundamentally wrong with current corporate-governance structures and the language of corporate management. We just don’t have the proper lexicon to have a meaningful discussion about the kinds of risks that typical corporations face today, and we need to create a new field of “risk accounting” to address this gap in GAAP.

BUSINESS INSIGHT: Now that the financial landscape has been rearranged, are there things that corporate managers can do to capitalize on the current environment?

DR. LO: One of the things companies are surely going to have to deal with over the next year or two is greatly reduced liquidity in the capital markets. Borrowing costs are going to go up, and it’s going to be much harder to finance new ventures, so companies will have to be much more creative about rebalancing their pension-fund obligations and raising capital to fund operations. Managers should be prepared for some tough times.

At the same time, there’s going to be tremendous interest on the part of, say, pension funds in finding new ventures. My guess is that starting this summer, pension funds will begin increasing their allocations to private equity, hedge funds and other alternative investments—assets will be flowing back into risky ventures with a vengeance. The money that’s currently in T-bills has got to go somewhere—and anybody who has cash is going to be in a great position. Companies are going to have to find creative ways to tap into these nontraditional sources of financing.

New Opportunities

BUSINESS INSIGHT: What kinds of new market opportunities do you see emerging—things that aren’t typical?

DR. LO: Well, if you think about the kind of dislocation that’s affected financial markets, you’ll see that much of the current crisis stems from the fact that it’s very difficult to get information about the value of certain mortgage-backed securities because they’re so heterogeneous.

What if there was a service like eBay Inc. that provided a price-discovery mechanism for these mortgage pools? An electronic market for mortgages or mortgage-backed securities—something that’s easy to use and that allows users to value these illiquid securities quickly—could be an extraordinarily valuable service, particularly if it gains any kind of market share, like eBay.

It would allow holders of mortgage-related instruments to post their securities online and allow investors to bid on them. It would show prices on a historical basis so bidders could see how a portfolio of mortgages from a particular region of the country traded four months ago. Like eBay, it would provide a wealth of information and, ultimately, liquidity—that’s the key.

2 Responses to “Understanding Our Blind Spots”

1. dickpurcell Says:
   March 23rd, 2009 at 3:02 pm

   In response to your first two questions, on the most important implication of the financial crisis and what caused it, Dr. Lo points toward corporate leaders and governance. I wish he had pointed to investment professors and their governance.

   Investment is not like string theory, where theorists can pursue whatever satisfies their desires for conceptual complexity. It bears responsibility for delivering comprehension to non-mathematicians whose investment decisions shape our economy. In this regard, university investment education has become a national danger. Instead of conveying comprehension through clarity, it’s flooded the nation’s investors large and small with confused, confusing complexity.

   While the current focus is on the effect of investment complexity in confusing Wall Street off the cliff, my concern is for the 99.9% of American investors who are individuals investing for retirement and other lifetime dollar goals. For them –- for the legions of credentialed financial planners, investment advisors, and other fiduciaries who guide them –- what investment professors at hundreds of universities teach amounts to confused, confusing misapplication of investment theory to feed The People’s investment growth potential into the financial industry fleece machine. First, divert the focus from the investor’s future dollar goals to theories for the individual year, aka “return” and “risk,” where investors cannot see where they are going nor the terrible long-term drag-on-compounding cost of higher fees. Then apply the deception that gambles on investment managers speculating WITHIN asset classes is “investing in asset classes,” to switch the investors’ money into funds with higher fees. Teach this misguidance in such floods of complexity that the investment advisors and even their professors have no comprehension of what they are teaching and doing.

   How about the universities uproot and replace the current regimes in investment “education”? Out with the high priests of confused, confusing investment complexity. In with new teachers of investment comprehension conveyed with concise clarity.

2. shukiw1 Says:
   March 24th, 2009 at 5:09 am

   I think that a trivial daily fact escaped Dr. Lo’s attention.
   It is far morק important what you do daily in a firm than the big Drama involved in one or two big transactions/loans.

   True. It is crucial for investors to have a good fast assessment tool of risk.

   But it is far more important that many firms understand how risky is each and every operation and decision they do daily.
   Because in the end, they consume the investments that way .
   There is a flaw in management view of Risk, because there is an underestimation of complexity of projects and daily change in markets .

   The main impact of this crisis seems to be the urgent need for more complexity-sensitive managers in the”cockpit” of the firm.
   These managers tend to be more Reflective Thinkers and more willing to take into account the repercussions of their decisions.
   They must be less greedy and more accountable.

   How is that with impatient investors???

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