Andrew Lo: Reconsidering our notions of risk

Dec 19, 2010 @ 12:01 am

Andrew Lo wants investors — institutional and individual — to reconsider their notions of risk. He certainly has the credentials to make his case.

As the Harris & Harris Group Professor of Finance at the MIT Sloan School of Management and director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering, Mr. Lo is one of the nation's leading financial academic thinkers. He also is a fellow at the National Bureau of Economic Research and a member of the Economic Advisory Board of the Financial Industry Regulatory Authority Inc.

In addition, Mr. Lo is chairman and chief investment strategist of AlphaSimplex Group LLC. He founded the investment management firm in 1999 and continues to run it after selling it three years ago to Natixis Global Asset Management.

The quantitative funds that Mr. Lo created and advises use insights based on his adaptive-markets hypothesis, which contends that markets are not perfectly efficient but rather highly adaptive and competitive. In Mr. Lo's view, markets are rational most of the time, although they can and do react irrationally at times, based on fear, greed and other human emotions.

But even irrational behavior can be understood, he believes, so he and his fellow researchers at AlphaSimplex have built models and algorithms that attempt to account for overconfidence in certain market sectors and extreme risk aversion in others.

Based on his research, Mr. Lo recently urged the board of the California Public Employees' Retirement System, the nation's largest public-pension fund, to reassess its conservative risk management and asset allocation policies.

“When the environment becomes unstable, then it's the height of irresponsibility to keep a static portfolio,” he told the CalPERS directors, according to Bloomberg. “This notion of tactical risk management is going to become more important than ever before.”

Mr. Lo is working on an initiative to encourage regulators and policymakers to investigate systemic risk. His goal is the creation of an entity — akin to the National Transportation Safety Board — which would investigate the causes of financial panics and meltdowns. His concern is prompted by the latest market collapse, after which sweeping financial reform was written and passed by Congress before the Financial Crisis Inquiry Commission even submitted its final report. Such an investigative board would guard against acting without deliberation.

To help shed light on the issue of systemic risk, Mr. Lo co-organized a conference held at the Federal Reserve Bank of Chicago last week that brought together international regulators, academics and market participants.

“The problem is that you can't manage what you don't measure,” Mr. Lo said. “And since we don't have a single measure of systemic risk, we can't say whether it is higher or lower today than it was before.”

— Davis D. Janowski

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