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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.

The decision by the Nobel committee to recognize Markowitz, Miller and Sharpe brought legitimacy to the field of finance. It was also a key endorsement of the major assumptions underpinning modern financial theory — that markets are efficient and that investors have rational expectations and can process information quickly and accurately. The Efficient Market Hypothesis, introduced in 1970 by University of Chicago Booth School of Business finance professor Eugene Fama, and CAPM suggest that it is difficult, if not impossible, for active investors to beat the market.

Not surprisingly, the asset management industry has embraced Modern Portfolio Theory, which is basically a user’s guide on how to construct an “efficient,” or well-diversified, portfolio, maximizing the investment return for a given level of risk. Fund managers, however — apart from Vanguard Group and a few other companies that have built their businesses on indexing — have not embraced the notion that markets are efficient. For support, they can turn to the field of behavioral finance, which Santa Clara University finance professor Hersh Shefrin defines as “the application of psychology to the study of financial decision making and financial markets.”

Behavioral finance traces its roots to the research of Israeli psychologists Daniel Kahneman and Amos Tversky, who through a series of experiments starting in the late ’60s showed that people are not always rational when making decisions and make mistakes in judgment because of heuristics and cognitive biases. By the 1980s reports of anomalies — including unexplained investor and market behavior as a result of the effects of loss aversion, mental accounting, overconfidence and overreaction — began appearing in professional journals, by economists such as Chicago’s Richard Thaler (then at Cornell University) and Yale’s Robert Shiller, calling into question the dogma of rational behavior.

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“It was [British economist] Alfred Marshall who said over 100 years ago that economics is not an exact science,” Shiller, 66, explains. “The problem is, it’s the study of people. There’s some mysterious extra that comes with human will and intention. But it’s very hard to reduce to a formula.”

From the outset neoclassical economists rejected the behavioral school. “There’s no behavioral theory; it’s all just inefficient markets,” says Fama, 73. “It’s a big blanket, not a theory of its own. Unless there’s a coherent theory that can be subjected to tests, there’s nothing to replace [the Efficient Market Hypothesis] with.”

The neoclassical finance camp has had a strong supporter in Boston University finance professor Zvi Bodie, co-author with Alan Marcus and Alex Kane of Investments, the textbook used by most U.S. MBA programs. Although the book, now in its ninth printing, devotes one chapter to behavioral finance, Bodie is clearly not a believer. “Shiller and all those people are basically wrong,” he says. “They know it but won’t admit it.”

The debate — some would say battle — between the neoclassical finance school and behavioral theorists has yet to be settled. That’s because one critical factor has not been addressed by either camp, posits Paul Woolley, senior fellow at the London School of Economics. In The Future of Finance, published by the LSE in 2010, Woolley calls for “a science-based, unified theory of finance . . . that retains as much as possible of the existing analytical framework and at the same time produces credible explanations and predictions.”

He is looking for a solution in the principal-agent relationship.

Woolley, along with his colleague Dimitri Vayanos, a professor of finance at the LSE who has taught at both the MIT and Stanford business schools, believes that capital market booms and crashes have discredited the Efficient Market Hypothesis. “The idea that the markets are efficient is 40 years old,” says Woolley. “That’s no longer credible. We’re offering an alternative paradigm.” Specifically, Woolley and Vayanos assert that private, individual investors do not set prices because they delegate virtually all of their investment decisions to financial intermediaries, or agents. Delegation creates an agency problem.

After 25 years as partner, then chairman, of asset manager GMO’s London office — which he opened — Woolley in 2007 established the Paul Woolley Center for the Study of Capital Market Dysfunctionality at the LSE, naming Vayanos as director. Through this institution Woolley is offering a new theory of finance that he hopes will produce credible explanations and predictions for market behavior. “Two things happen if you introduce the principal-agent problem,” says Woolley, 73. “One, you get asset mispricing, as markets are momentum-driven. Two, the agents are in a position to capture excess returns that should go to the asset owners.”

Momentum — the tendency of a stock or market to continue in the same direction it has recently been moving — is incompatible with efficient markets, argues Woolley, and has been difficult to explain, even by the likes of Fama. In 1993, Fama and colleague Kenneth French (now a finance professor at Dartmouth College’s Tuck School of Business) introduced a “three-factor model” to explain the momentum and value effects that contradict the Efficient Market Hypothesis. But Vayanos has a different take on it. He is currently working on a new model for asset pricing that incorporates how individuals choose their asset managers and how money flows from manager to manager. The problem, as Vayanos sees it, is that investors have incomplete knowledge of their managers. So when an investment fund is underperforming, investors — who can’t tell if the manager is incompetent or prudently avoiding overpriced stocks — take away their money and give it to managers who are outperforming. In that way, the overpriced securities held by the outperforming managers are driven higher. This mispricing is not caused by investors’ irrationality or stupidity, says Vayanos, but rather by their imperfect knowledge of the agents managing their money.

“These flows can account for the momentum and value effects,” he adds. “Our agency-based view says maybe everything can be understood in a fully rational world.”

MIT’s Lo spent the first ten years of his career trying to explain away the conflict between the rational theory he had been taught in graduate school and the behavioral finance literature he read afterward. Part of that time he was an assistant finance professor at the University of Pennsylvania’s Wharton School, where he and fellow professor A. Craig MacKinlay looked at every market anomaly that had been documented to see whether there was some kind of empirical explanation for them. They couldn’t find any. “I tried all sorts of ways of explaining away the results, but ultimately I realized it would be a lot easier simply if we understood that the Efficient Market Hypothesis has limitations,” Lo says.

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