WEBVTT - Interview With Andrew Lo: Masters in Business (Audio) 0:00:00.160 --> 0:00:02.480 The future may not be clear, but our commitment is 0:00:02.640 --> 0:00:04.480 so when you sit with an advisor at Merrill Lynch, 0:00:04.559 --> 0:00:07.200 we'll put your interests first. Visit mL dot com and 0:00:07.280 --> 0:00:09.680 learn more about Merrill Lynch. An affiliated Bank of America, 0:00:09.800 --> 0:00:12.039 Mary Lynch makes available products and services offered by Merrill 0:00:12.080 --> 0:00:14.520 Lynch Pierce Veneran Smith Incorporated or Register Broker Dealer remember 0:00:14.560 --> 0:00:19.840 s I PC. This is Masters in Business with very 0:00:19.920 --> 0:00:25.840 Ridholtz on Boomberg Radio. This week on the show, I 0:00:25.920 --> 0:00:29.840 have an extra special guest, Professor Andrew Lowe of m 0:00:29.920 --> 0:00:33.159 I T. I first heard Professor Lowe speak at a 0:00:33.200 --> 0:00:37.920 conference about a decade ago, and I was I was 0:00:38.120 --> 0:00:43.159 quite fascinated by his willingness to I don't want to 0:00:43.159 --> 0:00:47.879 say attack, but take on the efficient market hypothesis and 0:00:48.040 --> 0:00:53.320 adapt it uh to what he sees as some obvious 0:00:53.800 --> 0:00:59.680 modern changes in how people in technology are interacting with markets, 0:01:00.160 --> 0:01:03.240 be they more efficient or less efficient. It's pretty clear 0:01:03.720 --> 0:01:09.800 that the strong efficient market hypothesis, which essentially states markets 0:01:09.800 --> 0:01:13.399 reflect the all information about stock prices in any given 0:01:13.400 --> 0:01:16.399 instant's a little bit of an overstatement. You have to 0:01:16.440 --> 0:01:21.479 work in the actual human side, the emotions and and 0:01:21.520 --> 0:01:26.120 as well as the adaptive side, how markets are consisting 0:01:26.200 --> 0:01:30.680 of organic participants and they themselves become organic and adapt 0:01:30.720 --> 0:01:36.200 to changes fairly rapidly. UM. I think Professor Lowe's read 0:01:36.280 --> 0:01:41.320 on the efficient efficient market hypothesis predated the Nobel Committee 0:01:41.720 --> 0:01:44.919 giving Bob Shiller of Yell and Gene Fama of chicag 0:01:45.120 --> 0:01:50.680 University of Chicago uh CO Nobel prizes, one for m 0:01:50.840 --> 0:01:54.040 H and the other for behavioral economics the same year. 0:01:54.280 --> 0:01:56.960 It's not a coincidence, and and he very much was 0:01:57.040 --> 0:02:00.640 clued into that before the Nobel Committee was. Anyway, if 0:02:00.720 --> 0:02:03.880 you are at all interested in how markets operate, how 0:02:03.920 --> 0:02:07.880 they adapt, what investors do that's right and wrong, and 0:02:08.120 --> 0:02:12.240 as well as the significance of hedge funds within the 0:02:12.360 --> 0:02:16.200 universe of market participants, I think you'll find this to 0:02:16.240 --> 0:02:19.520 be a fascinating conversation. So, with no further ado, my 0:02:19.639 --> 0:02:25.240 conversation with Professor Andrew low of m I T. This 0:02:25.639 --> 0:02:29.760 is Masters in Business with Barry Ridholts on Bloomberg Radio. 0:02:32.000 --> 0:02:35.480 My special guest today is Professor Andrew Lowe of the 0:02:35.680 --> 0:02:38.720 m I T. Sloan School of Management. He has been 0:02:38.760 --> 0:02:43.000 the director of m I T. S Laboratory for Financial Engineering, 0:02:43.400 --> 0:02:47.720 since he comes to US with a PhD in economics 0:02:47.720 --> 0:02:51.440 from Harvard. He briefly taught at Wharton before going to 0:02:51.639 --> 0:02:54.600 m I T and is the author of numerous books 0:02:54.639 --> 0:02:58.959 about finance, including A non random Walk Down Wall Street, 0:02:59.320 --> 0:03:03.400 Analytic Perspective on hedge Funds, The Evolution of Technical Analysis, 0:03:03.680 --> 0:03:08.360 most recently Adaptive Markets, Financial Evolution at the Speed of Thought. 0:03:08.720 --> 0:03:11.840 Professor Andrew Low, Welcome to Bloomberg. Thanks for having me. 0:03:12.000 --> 0:03:14.079 I'm thrilled you here. I've been a fan of your 0:03:14.200 --> 0:03:18.080 work for a long time. Let's jump into your background 0:03:18.120 --> 0:03:19.920 a little bit before we get to some of the 0:03:20.680 --> 0:03:26.000 heavy financial engineering work. Ironically, you right that you weren't 0:03:26.000 --> 0:03:29.600 an especially good math students as a kid, and yet 0:03:29.600 --> 0:03:33.000 you end up in a field that is dominated by 0:03:33.120 --> 0:03:36.440 heavy mathematics. How did that come about? Well, you know, 0:03:36.480 --> 0:03:38.360 I didn't know this at the time, but when I 0:03:38.400 --> 0:03:41.520 was going through elementary school and middle school, UM, I 0:03:41.600 --> 0:03:45.840 had a learning issue, which was I guess the mathematical 0:03:45.880 --> 0:03:49.760 equivalent of dyslexia. I think it's called DS calculia really, 0:03:49.800 --> 0:03:52.600 and uh, I had a terrible time memorizing the multiplication 0:03:52.640 --> 0:03:56.800 tables and were you transposing exactly? And uh, some of 0:03:56.840 --> 0:04:00.320 my teachers told my mother that they thought I was 0:04:00.640 --> 0:04:02.880 mentally retarded. That was the term of art in those 0:04:02.960 --> 0:04:06.000 days and um, but it was a third grade teacher, 0:04:06.120 --> 0:04:08.400 Mrs Barbara pick Laura that saw something in me and 0:04:08.520 --> 0:04:12.200 encouraged me and appointed me to this position of class scientists, 0:04:12.520 --> 0:04:15.600 where I was able to do experiments and demonstrate the 0:04:15.760 --> 0:04:18.520 various kinds of knowledge that I had gotten over the 0:04:18.520 --> 0:04:22.320 course of several periods during the school and that really 0:04:22.400 --> 0:04:25.280 boosted my self confidence. I still struggle with math until 0:04:25.360 --> 0:04:29.680 high school, where the new math came about, and which 0:04:29.760 --> 0:04:33.520 is essentially when we talk about new math, we're talking 0:04:33.560 --> 0:04:38.719 about what well replacing algebra, trigonometry, and geometry with things 0:04:38.800 --> 0:04:43.680 like group theory, ring theory and abstract algebra. And it 0:04:43.760 --> 0:04:47.120 was an incredibly important moment for me because I went 0:04:47.120 --> 0:04:49.320 from a C student in math to an A student 0:04:49.360 --> 0:04:52.240 pretty much overnight. And it was because I could handle 0:04:52.440 --> 0:04:56.360 abstract concepts much better than being able to do multiplication, 0:04:57.040 --> 0:04:59.039 and so it was a really wonderful thing. I know 0:04:59.080 --> 0:05:00.839 that new math is viewed is a failure in New 0:05:00.920 --> 0:05:03.040 York City back in the nineteen seventies, but for me 0:05:03.480 --> 0:05:06.480 it was a godsend. So now let's let's jump forward 0:05:06.520 --> 0:05:09.640 a little bit and and bring the idea of abstract 0:05:09.680 --> 0:05:13.760 concepts to markets. What's more important to markets supply and 0:05:13.839 --> 0:05:17.120 demands or fear and greed? Well, you know the answer 0:05:17.160 --> 0:05:19.760 is both. And that's really the interesting thing that I 0:05:19.839 --> 0:05:23.640 discovered about human nature. We have two aspects to our 0:05:23.680 --> 0:05:28.000 cognitive functions. Were incredibly good at logical deliberation and being 0:05:28.040 --> 0:05:31.880 able to balance supply and demand using various fancy mathematical 0:05:31.920 --> 0:05:34.640 and statistical tools. But at the same time, every once 0:05:34.640 --> 0:05:37.760 in a while, we freak out. And when we freak out, 0:05:38.120 --> 0:05:41.280 emotion rules today, and fear and greed then take over. 0:05:41.520 --> 0:05:44.279 And it's this jackal and hide aspect of human decision 0:05:44.279 --> 0:05:47.120 making that I think we're missing in economics being able 0:05:47.160 --> 0:05:51.359 to integrate those two. So behavioral economics has become a 0:05:51.520 --> 0:05:57.200 huge field between Professor Schiller, Professor sailor Danny Kahneman. Go 0:05:57.279 --> 0:05:59.599 down the list of all the folks um who have 0:06:00.279 --> 0:06:03.320 who have worked in this area. What does this say 0:06:03.600 --> 0:06:07.440 about the efficient market hypothesis? Is it wrong or is 0:06:07.480 --> 0:06:11.240 it simply incomplete? Yeah, it's definitely not wrong. There's some 0:06:11.480 --> 0:06:15.240 very important elements of efficient markets hypothesis that actually can 0:06:15.279 --> 0:06:18.599 protect us from making some pretty bad investment mistakes. But 0:06:18.880 --> 0:06:21.359 it is incomplete in the sense that it doesn't capture 0:06:21.440 --> 0:06:23.840 the fear and greed aspect of it. And I think 0:06:23.880 --> 0:06:26.159 it's trying to integrate the two that really got me 0:06:26.200 --> 0:06:29.400 to start thinking down the road towards adaptive markets. So 0:06:29.480 --> 0:06:37.360 let's talk about another duality. Rational rationality and irrationality coexist 0:06:37.600 --> 0:06:41.520 even within the same person. How does that manifest itself 0:06:41.640 --> 0:06:44.880 in in investment. Well, you know, it really comes from 0:06:44.920 --> 0:06:49.800 the neuroscientific aspect of decision making. So neuroscientists like Antonio 0:06:49.880 --> 0:06:52.520 Dimazio have come up with a really interesting notion of 0:06:52.560 --> 0:06:56.799 what rationality means. And what he developed was this idea 0:06:57.040 --> 0:07:02.400 that rationality actually requires a certain degree of emotion. In 0:07:02.400 --> 0:07:04.479 other words, when you take a look at patients that 0:07:04.600 --> 0:07:08.320 have had brain surgeries that have removed the emotional part 0:07:08.360 --> 0:07:10.960 of the brain, they end up acting in a very 0:07:11.000 --> 0:07:14.120 irrational way because they have no way of balancing the 0:07:14.200 --> 0:07:16.840 various different demands on their time. You know, when we 0:07:16.840 --> 0:07:19.360 think about showing up to work on time or meeting 0:07:19.360 --> 0:07:22.720 a deadline, emotion actually plays an important role in those 0:07:22.800 --> 0:07:26.680 kinds of behaviors. So with the proper balance of emotion 0:07:26.800 --> 0:07:30.400 and logical deliberation, we end up seeming quite rational. But 0:07:30.400 --> 0:07:32.960 when that balance goes askew, when we have too much 0:07:33.040 --> 0:07:35.640 or too little emotion, we end up making mistakes. And 0:07:35.680 --> 0:07:38.480 that's very much along the same lines of how investors 0:07:38.800 --> 0:07:43.240 actually behave. So when we talk about fear and greed, 0:07:43.320 --> 0:07:47.720 we're really talking about the moments when the irrational side 0:07:47.720 --> 0:07:51.360 of the brain takes over and the logic steps back, 0:07:51.400 --> 0:07:54.080 and no one says to themselves, g I'm gonna be 0:07:54.120 --> 0:07:56.720 able to time my in and out perfectly. I'm going 0:07:56.760 --> 0:07:59.200 to be able to jump back in despite having the 0:07:59.680 --> 0:08:04.440 being in a terrible crash. We just tend to panic exactly. 0:08:04.480 --> 0:08:08.320 And you know, panic is actually a very important evolutionary adaptation. 0:08:08.760 --> 0:08:11.720 Fear and greed are a lot older than the ability 0:08:11.760 --> 0:08:16.240 to solve differential equations, and so when we start becoming threatened, 0:08:16.600 --> 0:08:20.160 we will react emotionally and and for physical threats that's 0:08:20.160 --> 0:08:23.520 actually a great response, but for financial threats it doesn't 0:08:23.560 --> 0:08:26.800 work out nearly as well. I'm Barry Hults. You're listening 0:08:26.840 --> 0:08:30.240 to Masters in Business on Bloomberg Radio. My special guest 0:08:30.280 --> 0:08:34.320 today is Professor Andrew Low of m I. T. Sloan School, 0:08:34.360 --> 0:08:38.280 of management. Let's talk a little bit about economists, and 0:08:38.400 --> 0:08:42.600 especially financial economists. I've long been a fan of the 0:08:42.600 --> 0:08:47.160 phrase that economists suffer from physics envy, and there's a 0:08:47.240 --> 0:08:51.120 quote of years that I have to share. Physicists can 0:08:51.160 --> 0:08:57.320 explain of all observable physical phenomena using Newton's three laws 0:08:57.360 --> 0:09:03.480 of motion. Economists probably have laws that explain three percent 0:09:03.960 --> 0:09:09.720 of all economic behavior. Explain that, well, you know, economics 0:09:09.840 --> 0:09:12.600 is about a much more complicated subject in physics, and 0:09:12.640 --> 0:09:14.640 I think that's the first point that we have to 0:09:14.679 --> 0:09:18.520 grapple with. I think it was the physicist Richard Feynman 0:09:18.600 --> 0:09:22.319 who speaking at a Caltic graduation said, imagine how much 0:09:22.320 --> 0:09:25.320 harder physics would be if electrons had feelings, And I 0:09:25.360 --> 0:09:28.320 think that really captures it. We're dealing with people that 0:09:28.400 --> 0:09:31.520 have feelings, and they react emotionally, sometimes as opposed to 0:09:31.559 --> 0:09:35.120 logically and rationally, and so the laws of physics don't 0:09:35.160 --> 0:09:37.839 really apply to human interactions in the same way that 0:09:37.880 --> 0:09:41.280 they apply to particles in a gravitational field. And it's 0:09:41.360 --> 0:09:43.480 very tempting for us to use the mathematics and the 0:09:43.559 --> 0:09:46.520 mantle of physicists, but the fact is that we're dealing 0:09:46.520 --> 0:09:50.320 with a very different object to say the very least. 0:09:50.360 --> 0:09:55.760 So let's talk about the criticism of the profession. Do 0:09:55.800 --> 0:09:59.240 you think, first, do you think economists get unfairly criticized 0:09:59.400 --> 0:10:01.920 and if so, what four? I think they do get 0:10:02.000 --> 0:10:05.360 unfairly criticized for certain things. Uh. It was once said 0:10:05.400 --> 0:10:09.319 that economists predict five out of the last three recessions. 0:10:09.840 --> 0:10:12.480 And uh, of course, you know, we don't have a 0:10:12.559 --> 0:10:15.800 perfect track record or prediction, but neither do weather forecasters. 0:10:16.200 --> 0:10:19.640 The nature of the task is much more challenging, and 0:10:19.679 --> 0:10:22.720 so I think that people have to understand the difficulty 0:10:22.880 --> 0:10:25.360 in making these kinds of economic predictions. We're getting better 0:10:25.360 --> 0:10:29.400 all the time, but it's still not purely predictive science. 0:10:29.480 --> 0:10:31.960 We need to actually take into account the art of 0:10:32.080 --> 0:10:34.680 economic forecasts. So let me push back on that a 0:10:34.679 --> 0:10:37.120 little bit. Yeah, that whether people are not perfect, but 0:10:37.240 --> 0:10:39.880 they could usually tell you a day or so before 0:10:40.320 --> 0:10:42.559 if it's going to rain, or if there's a possibility 0:10:42.600 --> 0:10:46.560 of rain, bring your umbrella. It's always always couched in 0:10:46.679 --> 0:10:50.240 probabilistic terms, which if you say there's a ten percent 0:10:50.320 --> 0:10:52.440 chance of rain and it rains, hey, the one intent 0:10:52.600 --> 0:10:57.240 chance came in. But the big criticism about economists, especially 0:10:57.240 --> 0:11:00.960 in the past decade, has was how did you guys 0:11:01.000 --> 0:11:05.079 miss the single biggest financial crisis since the Great Depression? 0:11:05.320 --> 0:11:09.880 If you can't see that coming, how, how why should 0:11:09.880 --> 0:11:12.600 people rely on you? And I know that's a loaded question, 0:11:12.720 --> 0:11:19.800 but defend the entire profession for missing the financial crisis, Well, 0:11:19.840 --> 0:11:22.640 you know, I'm not sure we did miss it. For example, 0:11:22.880 --> 0:11:28.040 in two thousand and five, Bob Schiller, ragu Rajan, and myself, 0:11:28.440 --> 0:11:31.920 all three of us wrote papers that described stress fractures 0:11:32.160 --> 0:11:34.840 in the financial system. Bob Shiller talked a bit about 0:11:34.920 --> 0:11:37.040 the real estate market and how that was going to 0:11:37.120 --> 0:11:41.600 be another kind of irrational exuberance UH bubble that was 0:11:41.640 --> 0:11:44.760 about to burst. In two thousand and five, ragu Rajan 0:11:44.840 --> 0:11:48.599 talked about the banking system becoming over extended and developing 0:11:48.640 --> 0:11:53.480 these kinds of UH risks of financial crisis. And some 0:11:53.559 --> 0:11:55.720 of my students and I wrote about the fact that 0:11:55.760 --> 0:11:58.880 the hedge fund industry was also heading for another debacle, 0:11:59.080 --> 0:12:00.880 very much along the line NDS of what happened in 0:12:02.280 --> 0:12:04.760 and so there was evidence in the data, and all 0:12:04.800 --> 0:12:07.480 three of us wrote papers and gave talks about it. 0:12:07.800 --> 0:12:10.760 But the fact is that unless you've got a very 0:12:10.760 --> 0:12:14.520 strong notion from the entire financial profession that we're headed 0:12:14.520 --> 0:12:17.880 to a crisis. It's very difficult to engage in policies 0:12:17.960 --> 0:12:20.360 to try to do anything about it. And certainly the U. S. 0:12:20.400 --> 0:12:22.920 Treasury and the FED were not in a position to 0:12:23.000 --> 0:12:26.280 make very strong changes in policy because there was no 0:12:26.360 --> 0:12:29.160 official word like the National Weather Service to tell you 0:12:29.360 --> 0:12:31.640 that a hurricane was coming. We need to have something 0:12:31.679 --> 0:12:35.480 like a national weather service for financial crisis. Isn't that 0:12:35.559 --> 0:12:38.280 supposed to be part of the role of the Federal Reserve. 0:12:38.360 --> 0:12:41.880 Shouldn't they be looking at the sustainability of the system 0:12:41.920 --> 0:12:44.960 and looking for those hurricanes coming. Well, you know, that's 0:12:45.000 --> 0:12:47.960 part of their responsibility. But their focus is on the 0:12:48.000 --> 0:12:50.840 banking system, and as we know from the financial crisis, 0:12:50.920 --> 0:12:53.680 it was the shadow banking system that actually grew very 0:12:53.760 --> 0:12:56.880 very quickly, and that they don't actually have jurisdiction. But 0:12:56.920 --> 0:12:59.319 the other thing is that the FED has a dual responsibility. 0:12:59.360 --> 0:13:02.040 They're actually all is supposed to be encouraging economic growth 0:13:02.040 --> 0:13:05.560 with their monetary policies, and so it's very difficult when 0:13:05.600 --> 0:13:08.280 you've got this dual mission to be able to focus 0:13:08.320 --> 0:13:12.400 single mindedly on preventing financial crises from occurring. See I 0:13:12.440 --> 0:13:17.520 think that you yourself, um, Professor Schiller, and who was 0:13:17.559 --> 0:13:21.360 which was Raja? And there were a handful of others 0:13:21.440 --> 0:13:27.800 who had pointed out, um, the the huge um disquilibria 0:13:27.880 --> 0:13:31.160 that was existing in the in the system um. Righthart 0:13:31.160 --> 0:13:33.600 and Rogoff put out a paper in late oh seven 0:13:33.600 --> 0:13:36.400 early oh eight saying, hey, here's what the prior five 0:13:36.440 --> 0:13:39.720 financial crisis looked like and if the United States as one, 0:13:40.280 --> 0:13:43.000 which they were strongly implying, this is what we should expect. 0:13:43.320 --> 0:13:46.040 Turned out to be fairly prescient. But the run of 0:13:46.160 --> 0:13:49.400 people of economists who were warning or at least talking 0:13:49.440 --> 0:13:53.680 about it, UH are notable because they are the exceptions 0:13:53.720 --> 0:13:57.160 and the by and large most of the profession kind 0:13:57.160 --> 0:14:00.480 of missed it, Which raises the question how we learned 0:14:00.520 --> 0:14:03.760 anything from the last crisis, and might the profession be 0:14:03.760 --> 0:14:07.680 better suited to identify the next hurricane that comes along. Well, 0:14:07.720 --> 0:14:11.000 there's no doubt that the economics profession has been indelibly 0:14:11.120 --> 0:14:15.760 altered by the events of the past, chastened, absolutely humbled. 0:14:16.320 --> 0:14:19.800 We've had many individuals who have stated publicly that they 0:14:19.880 --> 0:14:24.960 felt economics, particularly macroeconomics, has let down the profession, and 0:14:25.000 --> 0:14:27.320 I think part of it was a devotion to these 0:14:27.520 --> 0:14:35.640 extraordinarily complex, rigorous mathematical formulations which were precise but precisely wrong. 0:14:36.280 --> 0:14:38.160 And uh, someone once said that it's better to be 0:14:38.200 --> 0:14:41.280 approximately right than precisely wrong. And I think we're sort 0:14:41.280 --> 0:14:44.560 of taking that now to heart. Do do we? Are 0:14:44.600 --> 0:14:49.880 we overly enamored with precision and data, specifically for things 0:14:49.920 --> 0:14:52.960 that as you described, You know, the the old joke 0:14:53.120 --> 0:14:57.680 is why why do economists um provide data to two 0:14:57.720 --> 0:15:00.400 decimal points? And the answer is to shoot show they 0:15:00.400 --> 0:15:03.320 have a sense of humor. Are we overly reliant on 0:15:03.440 --> 0:15:06.560 the illusion of precision? And is that part of the 0:15:06.560 --> 0:15:09.480 problem that we run into? Well, that's definitely a problem, 0:15:09.640 --> 0:15:12.240 and I think that a number of economists have written 0:15:12.240 --> 0:15:14.560 about it, and I believe that there is some kind 0:15:14.600 --> 0:15:19.040 of a reaction or a backlash to the mathematization of economics. 0:15:19.440 --> 0:15:22.200 There's no doubt that rigor has a role to play 0:15:22.240 --> 0:15:24.960 in our field. But someone once said that along with 0:15:25.040 --> 0:15:27.440 rigor usually goes mortis. So I think we have to 0:15:27.440 --> 0:15:31.160 be very careful about how we use mathematics. I'm Barry Ridholts. 0:15:31.200 --> 0:15:34.560 You're listening to Masters in Business on Bloomberg Radio. My 0:15:34.680 --> 0:15:38.280 special guest today is Professor Andrew Lowe of the m 0:15:38.320 --> 0:15:41.440 I T. Sloan School of Management, where he is the 0:15:41.480 --> 0:15:44.680 director of the m I T Labs for Financial Engineering. 0:15:45.080 --> 0:15:48.000 He has a PhD from Harvard and is the author 0:15:48.080 --> 0:15:54.720 of numerous books, including most recently, Adaptive Markets Financial Evolution 0:15:55.160 --> 0:15:57.600 at the Speed of Thought. Let's talk a little bit 0:15:57.600 --> 0:16:00.800 about the new book, because I I it's really fascinating 0:16:00.920 --> 0:16:03.680 and accessible. I don't want to call it a primer, 0:16:03.760 --> 0:16:08.120 but really a next generation look at how markets have 0:16:08.360 --> 0:16:12.760 changed over time and how investors should be interacting with them. 0:16:13.360 --> 0:16:16.280 Let me let me pull a quote right to begin with. 0:16:16.800 --> 0:16:20.840 The adaptive markets hypothesis is based on the insight than 0:16:20.960 --> 0:16:25.920 investors and financial markets behave more like biology than physics, 0:16:26.400 --> 0:16:32.080 comprising a population of living organisms competing to survive, not 0:16:32.360 --> 0:16:36.080 a collection of inanimate objects subject to the immutable laws 0:16:36.120 --> 0:16:41.640 of motion. How did you come about this biological organic 0:16:42.320 --> 0:16:48.480 explanation as opposed to the more traditional mathematical physics explanation. Well, 0:16:48.520 --> 0:16:51.560 you know I came about it. I guess really being dragged, 0:16:51.800 --> 0:16:55.480 kicking and screaming through various different disciplines. So the book 0:16:55.520 --> 0:16:59.720 is really a travelogue of my intellectual journey from a 0:17:00.000 --> 0:17:05.400 I heard devotee of efficient markets and rational expectations into 0:17:05.440 --> 0:17:09.440 the realm of first psychology and behavioral finance, and then 0:17:09.560 --> 0:17:12.960 to neuroscience and how people really make decisions, and then 0:17:12.960 --> 0:17:17.119 to the evolutionary biology of how our brain evolved, and 0:17:17.119 --> 0:17:21.000 then ultimately to the ecology of all of the various 0:17:21.000 --> 0:17:24.960 different dynamics of multiple competing species. So it wasn't that 0:17:25.000 --> 0:17:27.879 I was looking for these other disciplines, but they ultimately 0:17:28.000 --> 0:17:32.520 ended up becoming really important for understanding the very simple 0:17:32.560 --> 0:17:36.199 idea that you've got to explain these facts using as 0:17:36.400 --> 0:17:39.440 whatever tools you have at your disposal. We were speaking 0:17:39.720 --> 0:17:43.040 um off air that I had seen you Um give 0:17:43.040 --> 0:17:46.560 a lecture I think it was right after the financial crisis, 0:17:47.080 --> 0:17:50.760 trying to explain some of the reasons why markets were 0:17:50.800 --> 0:17:52.960 less efficient than they appear. How do you end up 0:17:53.000 --> 0:17:55.320 with a crisis and you end up with these wild 0:17:55.440 --> 0:17:58.840 highs and these crazy lows. If the markets are truly efficient, 0:17:58.880 --> 0:18:02.720 it can't be. That can't be the case. And the 0:18:02.760 --> 0:18:06.800 genesis of this process of the organic way of looking 0:18:06.840 --> 0:18:11.359 at markets were evident in your lecture. How long have 0:18:11.440 --> 0:18:14.119 you been playing with this idea? It has to be 0:18:14.160 --> 0:18:17.399 at least a decade, if not longer. Well, it's actually longer. 0:18:17.640 --> 0:18:21.960 It really started in when I started looking at the 0:18:22.040 --> 0:18:25.840 data for the random walk hypothesis. That's a particular version 0:18:25.840 --> 0:18:29.560 of efficient markets, which says that stock prices follow random walks. 0:18:29.600 --> 0:18:31.840 You can't predict where you're gonna be tomorrow based upon 0:18:31.880 --> 0:18:34.320 where you are today. At least that was the theory, 0:18:34.600 --> 0:18:37.119 And when my co author Craig McKinley and I started 0:18:37.160 --> 0:18:39.959 looking at the data, no matter which way we sliced it, 0:18:40.520 --> 0:18:43.600 we couldn't get the random walk to work. In other words, 0:18:43.600 --> 0:18:46.280 the data are not consistent with the random walk. There 0:18:46.320 --> 0:18:50.040 are predictability, there's some persistence and some momentum and other factors. 0:18:50.080 --> 0:18:52.640 In fact, you wrote a book A non random Walk 0:18:52.680 --> 0:18:55.919 down Wall Street, and you also wrote a book on 0:18:56.040 --> 0:19:00.080 the Heretics of Finance about technical analysts. How does that 0:19:00.200 --> 0:19:03.680 play into the biological approach? Well, so it was really 0:19:03.720 --> 0:19:06.800 looking at the technical analysis literature that got me to 0:19:06.840 --> 0:19:09.480 start thinking a little bit more broadly. For those of 0:19:09.720 --> 0:19:14.240 the listeners who don't know, technical analysis is really a 0:19:14.280 --> 0:19:19.760 somewhat disreputable uh field of study that academics often pooh pooh, 0:19:19.840 --> 0:19:22.520 but which I think actually has quite a lot of value, 0:19:23.119 --> 0:19:26.040 and it's the idea that you can use geometric patterns 0:19:26.040 --> 0:19:28.800 in price data to be able to make forecasts and 0:19:28.800 --> 0:19:32.520 to try to understand how markets move. The technical analysts 0:19:32.560 --> 0:19:37.240 from the nineties, forties and fifties really understood that markets 0:19:37.280 --> 0:19:40.520 were driven not just by supplying demand, but also by 0:19:40.640 --> 0:19:44.320 the nature of emotion, by fear and greed, and so 0:19:44.359 --> 0:19:47.760 they would actually come up with patterns, trends, reversals, and 0:19:48.320 --> 0:19:50.960 other kinds of tools that, for those days where they 0:19:50.960 --> 0:19:55.000 didn't have computers and fancy technology, actually allowed them to 0:19:55.080 --> 0:19:58.320 make pretty useful forecasts. And it was reading that literature 0:19:58.359 --> 0:19:59.920 that got me to start thinking a little bit more 0:20:00.000 --> 0:20:02.919 oddly that maybe the mathematical equations that we use in 0:20:02.960 --> 0:20:05.439 modern finance is not the be all, in the end 0:20:05.480 --> 0:20:08.840 all of how you think about financial markets. And to 0:20:08.880 --> 0:20:12.160 that point, another quote of yours were more impulsive over 0:20:12.200 --> 0:20:15.760 the short term and more logical over the long term, 0:20:15.880 --> 0:20:19.600 very reminiscent of Danny Kahneman's thinking fast and slow. Tell 0:20:19.640 --> 0:20:22.600 us what you mean by impulsive versus logical. Well, if 0:20:22.640 --> 0:20:25.159 you take a look at how people make decisions, it 0:20:25.160 --> 0:20:29.160 turns out that from the neurophysiological perspective, there are multiple 0:20:29.240 --> 0:20:32.560 competing components of the brain that are at work. For 0:20:32.720 --> 0:20:36.639 long term decisions where we have the luxury of thinking 0:20:36.680 --> 0:20:40.679 carefully and deliberating on various different choices, for example, asset 0:20:40.680 --> 0:20:45.680 allocation or retirement planning. We can make supremely rational, mathematically 0:20:45.720 --> 0:20:50.880 precise decisions. But then crisis hits, events happen and we react, 0:20:51.240 --> 0:20:55.359 and in those cases we're reacting emotionally, not necessarily logically. 0:20:55.960 --> 0:20:58.920 And it's the emotional components of the brain, which are 0:20:59.040 --> 0:21:03.119 far older than the ability to do mathematics, that kick in, 0:21:03.440 --> 0:21:05.880 and the way they kick in they really overwhelm us. 0:21:05.920 --> 0:21:10.240 We are overwhelmed by our emotional centers, and when that happens, 0:21:10.560 --> 0:21:14.520 the decisions that we make are not particularly good when 0:21:14.600 --> 0:21:17.879 it comes to for our financial health. I'm Barry rid Halts. 0:21:18.000 --> 0:21:21.800 You're listening to Masters in Business on Bloomberg Radio. My 0:21:21.880 --> 0:21:25.800 special guest today is Professor Andrew Lowe of the m I. T. 0:21:26.000 --> 0:21:29.119 Sloan School of Management. Let's talk a little bit about 0:21:29.240 --> 0:21:34.160 hedge funds, which you've written about extensively as well as 0:21:34.160 --> 0:21:38.520 written a book, Hedge Funds and Analytic Perspective. Let's start 0:21:38.560 --> 0:21:41.840 with a quote of yours. At the start, the general 0:21:41.880 --> 0:21:45.160 partner brings all the experience and the limited partners bring 0:21:45.240 --> 0:21:48.520 all the money. At the end, the general partner leaves 0:21:48.560 --> 0:21:51.159 with all the money and the limited partner leaves with 0:21:51.200 --> 0:21:55.000 all the experience. I find that to be a hilarious quote. 0:21:55.359 --> 0:21:58.320 How do you really feel about hedge funds? Well, you know, 0:21:58.359 --> 0:22:00.840 that was really meant to represent the kind of skepticism 0:22:00.880 --> 0:22:02.600 that a lot of people have for hedge funds. But 0:22:02.680 --> 0:22:06.000 I think that hedge funds play an incredibly important role 0:22:06.040 --> 0:22:09.200 in the financial ecosystem. They're the tip of the spear 0:22:09.359 --> 0:22:12.760 in terms of taking advantage of profit opportunities as they emerge, 0:22:12.920 --> 0:22:14.560 but they're also the canary in the coal mine. They 0:22:14.560 --> 0:22:18.080 get hit first when financial distress starts to develop. Why 0:22:18.280 --> 0:22:20.960 is that? Why are they so fast to react when 0:22:21.000 --> 0:22:26.240 an opportunity exists, but sometimes fast to embrace risks that 0:22:26.880 --> 0:22:31.440 don't pay off in fact have a negative ramification. Well, 0:22:31.480 --> 0:22:35.120 it's because of their unregulated nature. Hedge funds are allowed 0:22:35.160 --> 0:22:37.960 to do anything and everything in order to make returns 0:22:37.960 --> 0:22:40.760 for their investors, and the fact that they are unregulated 0:22:40.840 --> 0:22:43.520 is actually really important. It's because it allows us to 0:22:43.600 --> 0:22:46.399 see what all of the various different dynamics are in 0:22:46.480 --> 0:22:50.160 financial markets unfettered by regulation of any sort. So they're 0:22:50.200 --> 0:22:53.720 the laboratory. They're the experiment where these different things take place. 0:22:54.080 --> 0:22:56.879 And while they're three trillion dollars, which sounds like a 0:22:56.920 --> 0:22:59.800 lot of money in the grand scheme of global and 0:23:00.000 --> 0:23:03.399 sestable assets, that really is a few percentage of total 0:23:04.040 --> 0:23:06.679 um money that's out there at work. Well, it seems 0:23:06.680 --> 0:23:09.760 like a small number compared to say, Vanguard. Vanguard just 0:23:09.800 --> 0:23:13.600 passed their four trillion two right, So the entire hedge 0:23:13.600 --> 0:23:16.280 fund industry is only three trillion, But that number is 0:23:16.320 --> 0:23:19.040 misleading because hedge funds can use leverage, and they can 0:23:19.119 --> 0:23:22.199 go short, and they can trade at much higher frequencies 0:23:22.200 --> 0:23:24.920 than say mutual funds, So that three trillion goes a 0:23:24.960 --> 0:23:27.800 long long way in terms of having market impact. And 0:23:27.840 --> 0:23:31.040 one of the things that I'm always surprised when people 0:23:32.440 --> 0:23:35.640 bring up the financial crisis and hedge funds, and somehow 0:23:36.040 --> 0:23:40.440 I believe hedge funds were responsible. They really survived the crisis. 0:23:40.520 --> 0:23:42.040 They might have taken a little bit of a beating. 0:23:42.359 --> 0:23:45.800 I think the numbers were down, but they certainly weren't 0:23:45.840 --> 0:23:47.879 the cause of the crisis. In any way, shape or 0:23:47.880 --> 0:23:50.480 form or or Am I overstating it? No, No, you're 0:23:50.560 --> 0:23:53.560 right that it's really hard to attribute cause to any 0:23:53.640 --> 0:23:56.440 one player in the system. I think we all contributed 0:23:56.440 --> 0:23:59.200 to the financial crisis in one form or another. It's 0:23:59.200 --> 0:24:01.600 really the complex city of the system and the fact 0:24:01.600 --> 0:24:04.480 that we have these non linearities that people really weren't 0:24:04.480 --> 0:24:08.320