ANDREW LO: FINANCIAL INNOVATION

May 9, 2014

Consuelo Mack: This week on WealthTrack, How do you prevent investors from constantly shooting themselves in the foot by chasing hot performance and selling at market lows? Professor Andrew Lo and his team at MIT’s laboratory for financial engineering are working on solutions to protect investors. That’s next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Investors are notorious for making bad market timing decisions. They tend to chase hot performance and sell at or near market lows. The latest research from the Bogle Financial Markets Research Center and Morningstar shows an all too familiar pattern. No matter what the mutual fund category investors underperform the very funds they invest in. Over the last 15 years for instance investors underperformed large cap growth funds by an average of 2 and a half per year… the gap with large cap value funds was almost 2 percent annually. For international stock funds the annual underperformance was nearly the same amount. And even bond fund investors lagged by 1.8% a year. But it’s not just individuals who make terrible timing decisions. It turns out corporations do too. According to some fascinating research covered by WealthTrack guest James Grant, in a recent Grant’s Interest Rate Observer, “we humans seem genetically incapable of buying low and selling high”. Grant’s went on to say “according to Factset, the average price at which the companies of the S&P 500 repurchased stock between the fourth quarter of 2012 and the third quarter of 2013 was 99.8% of the average price of the preceding 12 months. In other words, managements bought in shares, not because the price was low, or the value commanding. They bought in shares, as we read the managerial mind, because everyone else was buying them in.

This week’s WealthTrack guest is on a mission to help investors avoid their poor market timing and chronic underperformance. He is financial thought leader Andrew Lo, professor of finance at the MIT Sloan School of Management and head of its laboratory for financial engineering. Lo is a prolific writer for finance and economic journals and applies his research in the real world as founder, chairman and chief investment strategist at Alpha Simplex which runs a series of hedge fund like mutual funds under the Natixis name, including his flagship Natixis ASG Global Alternatives Fund. I began the interview by asking Professor Lo to describe his latest project at MIT which they have dubbed Artificial Stupidity!
Andrew Lo: Well, in a nutshell it’s trying to simulate realistic investor behavior. So often we think about investors as maximizing their self-interest and engaging in the right kind of investment activities, but in fact it’s very difficult for investors to follow what economists tell them they should be doing, and so what we wanted to do was to simulate actual investor behavior and ask the question, are investors able to earn a decent rate of return if they simply act the way they feel? And that’s the hope is to try to understand where they actually break down in terms of the decision-making processes.

Consuelo Mack: So let’s talk about, number one, there’s artificial intelligence and now you’re doing artificial stupidity. So where did that title come from?

Andrew Lo: Well, yeah, it’s a little bit of a …

Consuelo Mack: Tongue-in-cheek?

Andrew Lo: Tongue-in-cheek, yes, absolutely. Artificial intelligence obviously is a big part now of the financial industry. We have all sorts of algorithms that help us act smarter, but the problem is that what we need to understand is first where are we making the systematic mistakes, and so maybe artificial stupidity is a little bit too strong. Maybe we should say artificial irrationality. We want to understand how investors ultimately make the mistakes that we all do. Once we can identify and then replicate the mistakes, we can then simulate how an investor’s portfolio is going to be subject to those mistakes and then start beginning to think how to correct them.

Consuelo Mack: Supposedly we buy high and we sell low. So we chase performance, and we hate pain and losses so the minute our investments go down, we get out of them. So that’s wrong?

Andrew Lo: Well, it’s wrong to pull your hand out of the fire and leave it out for years and years. So when we lose money, and all of us will lose money at some point if we haven’t already, once we lose money, investors often go to cash and stay in cash way too long. By the time they realize it, they’ve missed out on some pretty attractive returns. For example the last couple of years the S&P’s done great. By the time they realize that it’s often too late. They’ve missed a pretty big rebound, and so the idea of understanding what drives us, what causes us to make these mistakes can actually tell us how to fix them or at least construct algorithms that will help us to act smarter.

Consuelo Mack: But you think that the buy and hold idea of investing is wrong. Correct?

Andrew Lo: Well, I would say that buy and hold is not wrong, but it’s incomplete, and it’s incomplete in the following ways. During normal times when the stock market is moving in reasonably acceptable levels of volatility where we don’t have huge crashes or huge run-ups, it’s actually pretty reasonable to buy and hold equities. For example, through the 1930s all the way up to the early 2000s, if you bought and held you would have done pretty well. The problem is that over the last decade the stock market has been much more of a roller coaster ride. Volatility shoots up and then it calms down, and it spikes up yet again, and so for the typical investors it’s not realistic to expect them to buy and hold over the last 10 years when you have peak-to-trough declines of up to 51 percent which is what we saw in 2008 and 2009. Nobody is going to sit idly by and watch half of their portfolio evaporate. They’re going to pull out much sooner than that, maybe after they lose 20 percent or 30 percent or 40 percent. At some point you’ve got to say it’s enough, and the problem is that in this kind of a market buy and hold can be deadly. If you aren’t really aware of the risks, you won’t be properly prepared for them.

Consuelo Mack: You mentioned pulling your hand out of the fire. Obviously when you start feeling pain, you should pull your hand out of the fire perhaps, and perhaps you should pull or at least reduce your exposure to the most risky assets which frequently are stocks. Therefore, what is it that you would have us do differently?

Andrew Lo: Well see, this is where the analogy may break down, and we have to be very careful about how we use it. So the reason that people pull their hand out of the fire is because if you don’t your flesh is going to start burning.

Consuelo Mack: You’ll get burned, yes.

Andrew Lo: So the question you have to ask is when you lose money in the stock market, are you likely to lose more money if you keep it in there? Or is it just a temporary blip, and that’s really the question that investors have to focus on. Over the course of a 70-year period, most of the time when you lose money it was a temporary blip. In fact, during the Internet bubble years, the only lesson that investors learned is to buy on dips. The problem is that over the last decade that lesson is not going to serve us as well as it did before, and so the key is to try to identify periods where you need to pull your hand out of the fire because it’s going to continue burning and other periods where it is a temporary blip and you can let it go and see what happens over the course of the long term.

Consuelo Mack: Is it possible to predict that?

Andrew Lo: Well, it may not be possible to predict it, but it’s possible to identify it, and that’s actually a very important distinction. We can’t predict the next crisis, but if we understand that we are in the midst of a crisis and react, we can close the barn doors after maybe 40 percent of the horses are gone as opposed to all of the horses being gone. So I think that being able to understand your current environment and being in a position to adapt to that environment can actually help you stave off some of these serious losses.

Consuelo Mack: Is this what the project’s attempting to do, is identify when you should cut and run and when you should stay?

Andrew Lo: It is but more importantly it’s trying to identify what individuals’ natural inclinations are and to try to see how that matches against the historical data and ask the question, under what periods is our natural inclination going to be beneficial and what other conditions will it actually be detrimental? If you can identify those two different kinds of environments, you can begin to start adapting more intelligently, and so the idea about artificial intelligence is first let’s figure out what artificial stupidity is, and then we’ll try to do the opposite.
Consuelo Mack: How far along are you in the process? Do you have any indications yet?

Andrew Lo: Well, you know, we’ve done the beginning scaffolding of understanding what all of the various different biases are, so I would say that there are probably 11 different features of human cognition that are particularly detrimental for financial investing, and so what we’re trying to do is to simulate those behaviors and to make sure that we’re actually replicating those behaviors in actual investors. Once we’re sure that we’ve got those behaviors properly replicated, we can then start doing the simulation of looking at various different environmental conditions that lead to good or bad outcomes.

Consuelo Mack: Are there behaviors that are more damaging than others? Are there like the top two worse behaviors that you can identify or have identified?

Andrew Lo: So the top behavior that’s damaging is actually not what most people think. Pulling your hand out of the fire, taking money and moving it into cash after big losses is actually not a bad thing. The really bad thing is leaving it in there way too long, so not going back in when you need to, and that’s the problem. It takes a while for investors to get comfortable again with the market after being burned, and that process can be deadly. We can lose out on huge returns if we wait too long to get back in. So we need more discipline in thinking about moving into and out of cash.

Consuelo Mack: Right now one of the major fears of many individual investors is market volatility, and my understanding is in some of the research that I’ve seen is that in fact individual investors and some institutions are underinvested in the stock market. Are we making the same mistake now?

Andrew Lo: I think it really depends on the horizon, and that’s another aspect of artificial stupidity. We don’t take into account enough the various different life stages that we might be in. So for example, a 60-year-old who’s thinking about retiring in another 10 or 15 years might look at things very differently from a 35-year-old who’s really just beginning to get into the most important parts of his or her career. So I think that horizon matters more than most people think but also risk tolerance. I think we have to go through the internal calculus of if I lose 20 percent, am I going to freak out? Or can I withstand up to 30 percent loss and still move on? Once you factor all of these considerations, you can actually construct the appropriate portfolio that’s going to be right for you. So I would argue that individuals have to start thinking about personal benchmarking. You know, we have personalized medicine now. Not surprisingly I think it’s because of the sophistication of the healthcare industry that we do that. I think we need to have personalized benchmarking so that we can understand exactly what would be appropriate for you which may be different from what’s appropriate for me.

Consuelo Mack: How close are we to having that kind of personalized approach to investing?

Andrew Lo: Well, I think the science is already there. What’s lacking is the engineering. So in other words, we have the theory. We know how to construct personal benchmarks to be specifically designed to fit your goals, needs and circumstances. We don’t yet have an easy way to implement that, and so what we need are more financial products that will allow us to take these personal benchmarks and put them into practice.

Consuelo Mack: The last time you were on, you said how much the markets have changed, that it’s not your mother or my mother’s market. It’s not even my market when I was younger, and a couple of things have happened. Government intervention in the markets is one thing. Technological advances, the fact that there are so many more players in the market. It’s a global market now, and that it requires a new attitude on the part of investors. So number one, are there any other seismic changes that you’ve identified since you and I last talked a year or so ago? And number two is, what are the kinds of adaptive behaviors that we should be following as individual investors?

Andrew Lo: Well, in terms of the seismic changes, there’s definitely big factors at work in driving markets, much more so than ever before. You know, certainly we’ve identified what those factors have been for the last several years. The Fed is probably one of the biggest, but we also have the European debt crisis that’s still outstanding, the Chinese real estate market that’s cooling down. There are a number of very, very big issues that are hanging over our head. Over the next 10 years I think we’re going to end up into a much better place for financial markets, but in order for us to get to those really 10 good years, we’re going to have to go through some pretty serious financial dislocation and reform. So within the next two or three, I wouldn’t be surprised if we run into another significant crisis, and there’s going to be a lot of new developments on the regulatory front that will have to be worked through before we get to that period of time. But I’m actually optimistic that after we work through those issues, and it may take another two years, another five years, there’s going to be a period of great prosperity. Once the financial system becomes reengineered, we’re going to see some tremendous growth.

Consuelo Mack: What is your view of the U.S. market now, and how risky is it for investors?

Andrew Lo: Well, I guess I would say it’s probably partly cloudy with some threat of showers in the sense that we have had a very good run over the last couple of years. The economy looks like it’s recovering, but the recovery is not without its issues, and so I think we’re in a transition period where it’s very easy for the market to turn. I expect that this year will be somewhat less rosy than last year. The growth will be somewhat more muted, but ultimately I think we’re actually transitioning to a pretty decent equilibrium. That equilibrium is going to be potentially threatened if we have some problems in other countries because now the economy is so globally interrelated, but barring that kind of a disaster I think that we’ll be able to get to a reasonable level of growth and employment.

Consuelo Mack: Let me read you something from AlphaSimplex, the company that you founded, and you’re now the chief investment strategist for and the chairman. “It is to help investors achieve greater diversification than traditional stocks and bond funds while actively controlling risk and liquidity.” How can I as an individual control risk for starters? What are some of the tools that I can use?

Andrew Lo: Well, to start with, you have to know what risks are. Someone said that you can’t manage what you don’t measure. So the first question is, how much risk have you got in your portfolio? You have to go through the various prospectuses, talk to a financial advisor, or some of the funds have quarterly calls. Participate on those to try to learn what risks are embedded in funds, and by risk I don’t just mean volatility which is what usually people mean when they think about risk. There are all sorts of risks, different dimensions of risk. For example, liquidity risk. If you’ve got your money in a real estate fund, there may be some liquidity issues so that when there’s a flight to quality because of some type of financial distress, those kinds of funds may be hit more than others. So try to understand what the different dimensions of your risk are, and then ask whether during certain periods of financial dislocation that’s going to hit your portfolio more than others or more than you would like. Once you understand what the risks are, you can then start to make changes in your investment decisions to try to manage those risks.

Consuelo Mack: Most Americans I would imagine have a fairly traditional portfolio of heavily invested in U.S. stocks, probably heavily invested in large cap U.S. stocks, and perhaps a sizable portion of their portfolio may be in corporate bonds, for instance. Again, very U.S.-centric. How risky is that kind of a portfolio.

Andrew Lo: So I think that’s a huge risk.

Consuelo Mack: Really.

Andrew Lo: And I think it’s really changed a lot over the course of the last couple of decades. So I think that nowadays investors also suffer from this diversification deficit disorder problem that we’ve spoken about before. The fact is that if you think you’ve got diversification from 500 securities, if those 500 securities are part of the S&P 500, you are not diversified. You have one big bet on U.S. equities, and it’s turned out over the course of the last several years that those bets may have done well in certain periods, but they’ve been disastrous in other periods. So the kind of diversification that I’m talking about is diversification across stocks, bonds, currencies, commodities, long and short but all in a portfolio that can be managed somewhat more actively for the risk if not for the alpha.

Consuelo Mack: And controlling the liquidity which again is an AlphaSimplex mission, you just described some of the ways that you can control liquidity. It depends on what you’re invested it, but aside from avoiding illiquid securities, is there another way to control liquidity?

Andrew Lo: Get a sense of how illiquid or liquid your assets are and then ask, what kind of illiquidity can you afford? Now, I would first suggest that illiquidity is actually a very good way to earn a higher rate of return. A good example is real estate. Most people have homes, and if you live in your own home you’ve got a pretty big illiquid investment, and if you’ve got a mortgage, it’s a leveraged investment. That’s not a bad thing if you’re living in a reasonable area and there’s price appreciation, but it is illiquid. So you have to recognize of your assets what’s liquid, what’s illiquid and how much illiquidity can you tolerate, or rather how much liquidity do you need? For example, to pay for your kids to go off to college or medical expenses, these are the kinds of things that we rarely think about in the context of investing. I think we have to bring it all together and think about them holistically.

Consuelo Mack: Oh, that’s very interesting. So you’re taking a completely holistic approach of all of the assets that you own not just financially liquid assets but real estate. I’m assuming you would put in art, collectibles, whatever, the whole nine yards.

Andrew Lo: Everything.

Consuelo Mack: And try to look and see where you are invested. You’ve launched a new fund at AlphaSimplex called the Natixis ASG Tactical U.S. Market Fund. It is a long-only U.S. equity fund. All right, so here you are. You are a huge proponent of broad diversification, you also run alternative investments. I mean, that’s what hedge funds are, but now you’re running a long-only U.S. equity fund? Explain what that is. It seems to be contrary to what your overall strategy is that you’re recommending for us and that you’ve done your entire professional life.

Andrew Lo: Well, actually it’s pretty consistent with what we’ve been doing, and really we decided to launch it because of requests that we got from existing investors. The basic motivation for this tactical U.S. equity market fund is that it makes use of the insight that during normal times, equity markets do pretty well. During abnormal times, and by abnormal I mean when risk is very high, when the volatility goes up, equities are almost never your friend. And so that insight translates very directly into a very simple strategy where if you’ve got money in equities during periods of high volatility, you should be underinvested in equities, and during periods of normal volatility, you should actually be overinvested in equities in order to compensate for the loss of the equity risk premium during the other periods of time. We’re invested in equities, but we use futures contracts as well as ETFs to provide extra exposure to equities when we see volatility going down and being normal, and when volatility starts to shoot up, we’ll actually go to cash so that we reduce the exposures, but most importantly we get back into equities dynamically as markets begin to recover, and we tend to do it in an automatic fashion so that we’re not relying on human judgment or lack of judgment.

Consuelo Mack: So how is it invested today?

Andrew Lo: Well, today it’s actually invested in equities. It’s completely invested in equities, and the volatility is actually at a pretty reasonable level, and so it’s certainly benefited over the course of the last year from that kind of a position.

Consuelo Mack: So interesting. One investment for a long-term diversified portfolio, what would you have all of us own some of? And I know you are a big proponent of having a very well-diversified portfolio.

Andrew Lo: Well, I would say some kind of managed futures fund mainly because that’s a bit off the beaten trail for the typical investor, so they wouldn’t normally think of it and because managed futures actually provides natural diversification during times of distress. Some people call that crisis alpha, and that’s something that’s hard to come by these days, particularly given the traditional investment products that all seem to point south when the going gets tough. So managed futures, you don’t need a lot of it in order to get the kind of diversification that they provide, but you need to start thinking about it and understanding what the risks and returns are, and that could actually be very beneficial for the typical investor.

Consuelo Mack: Non-correlated. They zig when the rest of the market zags. Five percent, is that enough to have in your investments portfolio to protect you?

Andrew Lo: Well, I think it depends on the level of risk tolerance but somewhere between five and twenty percent depending on age, circumstances, risk tolerance and so on. I think that would be actually a pretty good range to think about.
Consuelo Mack: Andy Lo, it’s so great to have you again on WealthTrack. Thank you so much …

Andrew Lo: Always a pleasure. Thanks for having me.

Consuelo Mack: … for joining us.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point picks up on Andrew Lo’s point that investors biggest mistake is not getting back in the stock market soon enough after a big market decline. The action point is: establish an automatic rebalancing discipline in your portfolio to avoid reacting emotionally to market volatility. As this graph from Vanguard shows semi-annual rebalancing of even a simple balanced portfolio can make a huge difference. Two portfolios, one “drifting” the way many investors have over the last decade and the other rebalanced semi-annually start with 42% U.S. Stocks, 18% international stocks and 40% U.S. Bonds. Both did well in the 2003- 2007 bull market with the drifting one outperforming. Both suffered 32% declines in the 2007-2009 bear market. But the automatically rebalanced portfolio reinvested back up to the targeted 60% stock position from the 2009 market lows whereas the drifting portfolio had gotten out of stocks and stayed out. Staying out of the stock market cost the drifting portfolio mightily with the systematically rebalanced portfolio up 151%, more than twice the gains of the drifting portfolio that failed to get back into stocks after the financial crisis. Vanguard admits this is an extreme example but as Professor Lo said holding cash way too long after a bear market is a common and costly mistake.

On our website’s extra feature this week, Professor Lo will discuss the broad interest he is generating with his mega fund project to battle cancer.

Also in our new WealthTrack Women section we will have updated financial advice specifically for women from our panel of women financial advisors. Have a great weekend and make the week ahead a profitable and a productive one.

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