Fully Invested

By Ken Shulman

A few years ago, while preparing to participate in a roundtable conference on finance, Andrew Lo happened upon the website of the American Psychological Association.

“Their mission statement focuses on applying their knowledge of psychology for the benefit of society,” says Lo, financial economist, hedge fund manager, and the Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management. “Reflexively, I compared it to the mission statement for the American Finance Association, which simply focuses on what we do and how we do it. It was quite a contrast. And I began to reflect, as a financial economist, on what our true mandate was.”

Lo has spent the better part of his professional life exploring that mandate. He is best known for his Adaptive Markets Hypothesis—a theory that incorporates human behavior, emotion, and even Darwinian evolution to better understand financial markets and assist investors in making constructive choices. Much of his research is aimed at mediating the impact of technology, global markets, and conflicting human emotions in an effort to make the world’s financial infrastructure more shock resistant: building safeguards that can avoid or mute the effects of computer-driven “flash-crashes”; drafting viable and effective regulations for an increasingly complex and technology-driven global financial infrastructure; and developing algorithms that can predict and ultimately help curb irrational and potentially damaging investment decisions.

But Lo’s boldest proposal to date may be his bid to help fight cancer. In 2012, he and his research collaborators launched the idea of a megafund that would use collateralized debt instruments to help bring life-saving cancer therapies to market swiftly and safely. On the business end, it was the type of proposal one might expect from a finance professional who oversees some $7 billion—the amount Lo manages in a series of mutual funds and managed accounts at AlphaSimplex Group, where he is chairman and chief investment strategist. What was novel was his analysis—and remedy—for the roadblocks that keep vital cancer therapies from reaching patients in a timely fashion.

“The drug development and approval process is increasingly challenging,” says Lo, who has lost several friends, colleagues, and family members, including his mother, to cancer. “The average cancer drug costs $200 million to develop, takes 10 years, and has only a 1 in 20 chance of being approved. Even if approval means large profits, the odds are just too risky for most investors.”

Troubled as he was by Big Pharma’s slow incubation periods and low success rate, Lo was even more disturbed to discover that many drug development decisions were driven by financial considerations, and not by science or patient need. “As the son of a cancer patient, I was outraged,” he says. “But I understood that a basic financing problem needed to be solved. Investors don’t like risk, whereas truly innovative therapies are usually very risky investments. You tend to strike out more often when you’re swinging for the fences.”

Lo’s solution to the drug-development riddle involves a pooling of risk, clever debt structuring, and, most importantly, enlightened leadership to ensure that drug development choices are dictated by patient need, and not just by investor greed. “As a financial economist, I’m not qualified to lead this effort,” says Lo. “A cancer patient needs a financial economist like a fish needs a 401(k) plan.”

Lo’s bold idea has since been explored in a series of “CanceRx” conferences at MIT. The blueprint calls for investors in the cancer megafund to purchase debt securities—the majority being long-term bonds, along with a smattering of derivative instruments. The capital would then be channeled into a pool of promising cancer research projects selected by a multidisciplinary team, including physicians, researchers, biopharma experts, and financial engineers. “If there are 150 statistically independent projects in your pool, your chances of picking at least three winners is 98 percent,” he explains. “This is a very low-risk investment that can offer investors an attractive rate of return. More importantly, it’s a formula that will create a fast lane for the some of most transformative treatments for cancer patients.”

The Power of Financial Engineering

The concept of using megafunds to spread the financial risk of costly and innovative research also holds potential, Lo believes, in myriad fields including manufacturing, energy, and even in confronting climate change. “We definitely need a new financial model to help finance longshots,” he says. “MIT recently announced a breakthrough in nuclear fusion. We’ll probably need another 10 years and about $5 to $10 billion in additional investments. We could use these new financing methods to reach the goal of the ‘gift of Prometheus’— bringing the power of the sun to the Earth.”

Lo’s range of activity stretches well beyond socially beneficial investment vehicles. As director of MIT’s Laboratory for Financial Engineering, Lo conducts research in two fundamental elements of contemporary finance: the explosion of technologies and instruments that have transformed the way money is measured and moved; and the idiosyncrasies of human behavior that dictate our often-irrational financial decisions. Technology, Lo notes, now enables automating trading programs to execute millions and millions of trades per day. This high-frequency trading—which is estimated to account for 50% of all global trading activity— provides investors with the liquidity they need in a financial universe where shares can be exchanged in a matter of milliseconds. Yet the rapid proliferation of trading tools, automation, and sophisticated financial instruments has also left the entire system more vulnerable than ever to wild fluctuations and potentially catastrophic crashes.

“Our global financial system has become so complex that no one individual is capable of conceptualizing it,” says Lo. “And this is frightening. But it also presents us with an opportunity to come up with a series of measures to assess systemic risk and to minimize or prevent it. There is no single measure that will tell us everything we need to know. But by bringing together all relevant stakeholders and developing multiple systemic risk measures, we can draft a series of regulations based on those measures that do the greatest good for the greatest number of people.”

While Lo believes that financial technologies need human oversight to be most effective, he also thinks that humans—in this case individual investors—could benefit from a little bit of cyber-shepherding. Too many investors, he observes, sell assets during moments of panic, only to regret not having stayed the course. Lo believes the industry can engineer a series of algorithms that can help investors better assess their long-term goals, their true tolerance for risk, and even communicate with them in moments when emotion might cloud their better judgment. Imagine a robo-call from your investment advisor telling you to sit tight during a sharp market dip.

“The science of human emotion is much more evolved than it was 10 years ago,” he says. “Neuroscientists are now beginning to map the biological basis for decision making and emotion. Once we understand these things better, we can come up with algorithms that can recognize the circumstances when you as an investor might be contemplating a rash decision, and call or text you to help you keep steady.”

Technology, Lo believes, is a two-edged sword; it’s up to us to ensure it’s used and not abused. The same goes for emotion, particularly in finance. “The emotion of greed, for example, can be good,” he says. “But only if it’s properly channeled and managed. Left to its own devices, greed can be incredibly destructive. The same is true for powerful technologies. I believe we, as financial economists, have the means and the responsibility to help people apply technologies and manage our emotions wisely, to their own benefit and to the benefit of society. This, if anything, should be our mission statement. We can do well by doing good, and finance doesn’t have to be a zero-sum game if we don’t allow it.”