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Future of Finance

MIT SLOAN SCHOOL OF MANAGEMENT FINANCE PROFESSOR Andrew Lo traces his interest in economics to a seemingly unlikely source: science fiction author Isaac Asimov. As a student at New York’s Bronx High School of Science in the mid-’70s, Lo was a fan of Asimov’s Foundation series, whose central character, Hari Seldon, develops a fictional field of study called psychohistory that combines history, psychology and statistics to predict the actions of a large group of people. “The idea that you couldn’t tell what an individual was going to do but that you could say with more certainty what a population of individuals might do struck me as being quite plausible,” explains Lo, who graduated in three years from Yale University with a BA in economics in 1980 and earned his Ph.D. from Harvard University four years later at the age of 24. “That’s exactly what the field of financial economics is all about.”

Today academics like Lo are drawn to finance because it deals with very practical real-world problems such as what an asset is worth or where to invest capital. For those with a strong quantitative bent — Lo, for example, originally intended to major in biochemistry, math and physics at Yale — finance is especially attractive as a laboratory in which they can develop and test their theories. But for much of the history of finance, which has been around for as long as there have been markets, serious economists largely ignored the field. It didn’t start to attract the attention of theoreticians until the 1960s and ’70s.

“Prior to then finance had been pretty much the purview of business schools, which were pretty nontheoretical places with lots of institutional material and rules of thumb,” says William Sharpe, 78, who is now retired after a long career teaching finance at Stanford University. “Then the economists invaded finance, asking questions about why people did things in a certain way and followed certain rules.”

Sharpe was among a band of young economists with revolutionary ideas for introducing uncertainty into finance and using computers to crunch data and run regression analyses. In 1964 he published a groundbreaking paper on the Capital Asset Pricing Model, which reduced to a simple formula the relationship between risk and return that most market participants already intuitively knew: To achieve higher returns, investors need to take on greater risks. CAPM introduced alpha (excess return) and beta (a measure of market risk) to the investment lexicon and became one of the pillars of modern, or “neoclassical,” finance. It also earned Sharpe the 1990 Nobel Prize in economic sciences. That year he shared the award with Harry Markowitz, the father of Modern Portfolio Theory, and Merton Miller, best known for his work on corporate finance.