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ANDREW LO: Any questions
from last lecture?

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Where we left off last time
was the adaptive markets

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hypothesis.

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The fact that markets are not
always in everywhere efficient,

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but rather they satisfy the
following six properties

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that I listed at the
end of last lecture.

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Individuals act in
their own self-interest,

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but they make mistakes.

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However, they learn and
adapt, and competition drives

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that adaptation and innovation.

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Natural selection,
essentially, is the mechanism

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that shapes the survival of
the heuristics And in the end,

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the only thing that
matters is survival.

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Now I illustrated how
heuristics develop

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by giving you an example of
the problem of getting dressed

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in the morning.

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And I pointed out
that each of us

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have our own heuristics
that have been developed

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over many, many
years of selection

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of various different sorts.

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So when you take
this all together

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and you put them
into a framework that

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tries to focus on
understanding market dynamics,

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you get a number of
implications that

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are actually quite different
from that of efficient markets.

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Let me tell you what they are.

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I'll give you some examples.

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One of the implications is
that the risk-reward trade-off

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the relationship between risk
and expected rate of return,

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like the CAPM's
security market line.

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That's not stable over
time or over circumstances,

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because individual
preferences are not stable

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over time or over circumstances.

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I'll give you an
example of that.

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Anybody know somebody who
has lived through the Great

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Depression, OK, so grandparents
or great-grandparents?

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My guess is that if
you talk to them,

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or if you even
observe their habits,

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they're actually quite
different from your parents

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and yourselves in
terms of how frugal

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they, are how careful
they are with money,

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with resources, even something
as simple as turning off

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the lights.

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A friend of mine is a customer
a very wealthy family.

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They own a private business.

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And so their family's
net worth today

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is probably in the
order of $300 million,

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which, even in today's
economy is worth a lot.

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Actually, it's worth more than
what it used to be worth now.

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And so this family, the
patriarch, the matriarch

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is their grandmother, who lived
through the Great Depression.

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And she lives in Lower
Manhattan in a relatively small,

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nondescript apartment,
despite the fact

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that the family, you
know, my friend's parents,

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live in a beautiful penthouse
apartment on Park Avenue.

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And they keep asking
the grandmother

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to move in with them.

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And she refuses.

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She just thinks it's a waste.

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It's embarrassing.

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And when she comes to visit
them, she'll take the bus.

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She refuses to take taxis
just from Lower Manhattan

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to Midtown.

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And so, you know, my friend,
you know, pleads with her.

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You know, Nana, why
are you doing this?

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You know, we have more money
than we'll ever be able to use.

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You can afford to take a taxi.

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Let us send a car for you.

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Why do you do this?

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It's dangerous for you to
take the subway or the bus.

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And she's like 95 years old.

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And she says to
him, listen, Sonny.

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You don't remember
the days that I do,

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when I had to stand in line
and wait for my dinner,

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not knowing whether or not I
was going to get me by the time

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I got to that end of that line.

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So don't you tell me that we
have more money than will ever

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be able to spend.

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I'm sure you've heard that.

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Those of you who know people who
lived through the depression,

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you've heard that.

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These individuals were indelibly
altered by their experiences.

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They're not the same
person before, as after,

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living through such
difficult times.

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And you're not going
to change them.

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So my friend has stopped trying.

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And so he just
does what he can in

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order to make her life easier,
but realizing that she simply

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can't enjoy the
same kinds of things

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00:04:54,280 --> 00:05:00,070
that he does, because she lived
through such traumatic times.

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00:05:00,070 --> 00:05:02,870
So if you understand that,
if you acknowledge that there

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are people that are indelibly
altered by tough times,

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00:05:06,260 --> 00:05:11,150
then, in the same way, people
can be indelibly altered

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00:05:11,150 --> 00:05:14,150
by really good times as well.

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As I said last time, you learn
nothing from your successes,

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00:05:18,031 --> 00:05:18,530
right?

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00:05:18,530 --> 00:05:20,450
Because you succeeded,
what's there to learn?

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00:05:20,450 --> 00:05:22,510
Do more of the same.

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00:05:22,510 --> 00:05:25,370
But that affects the
way you think as well.

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00:05:25,370 --> 00:05:29,560
And so what we think of as
this beautiful mathematical

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00:05:29,560 --> 00:05:32,770
relationship, this risk-reward
trade-off, the CAPM,

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00:05:32,770 --> 00:05:37,300
the CAPM works if all of the
assumptions that I specified

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00:05:37,300 --> 00:05:38,820
are true.

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But those assumptions
are predicated

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00:05:42,960 --> 00:05:45,240
on people acting rationally.

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00:05:45,240 --> 00:05:49,260
If people don't act rationally
for whatever reason,

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if they're emotionally
traumatized,

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if the balance between emotion
and logical deliberation

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has been permanently
altered, then the theory

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00:05:59,160 --> 00:06:00,700
is not going to work.

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So you have to understand that
when you're looking at markets,

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you're looking at
the complexities

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00:06:05,970 --> 00:06:08,400
of the interactions among
various different people

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with different balances
of logical deliberation

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and emotional response.

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So one of the
things that says is

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that risk premia,
the expected return

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00:06:20,730 --> 00:06:25,040
on risky assets as a whole,
is not a universal constant

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00:06:25,040 --> 00:06:27,530
like, you know, gravity.

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It changes over time
and over circumstances.

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00:06:31,650 --> 00:06:34,410
It was going to
be quite different

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00:06:34,410 --> 00:06:38,370
if we had continuing prosperity
over the next five years

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00:06:38,370 --> 00:06:40,740
as to where we're
likely to be headed now.

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It's just different.

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We have a different path
that we're going to follow.

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And so as things change, market
dynamics will change with them.

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Yeah, Zeke.

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AUDIENCE: So last
time, we had talked

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about when you give somebody
[INAUDIBLE] that [INAUDIBLE]

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and so on.

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00:06:58,677 --> 00:07:01,140
And you said that lasts
for a couple of hours.

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00:07:01,140 --> 00:07:01,785
ANDREW LO: Yes.

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00:07:01,785 --> 00:07:04,650
AUDIENCE: So with combined
with what you're saying today,

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00:07:04,650 --> 00:07:06,963
are you connecting
the two and suggesting

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00:07:06,963 --> 00:07:13,000
that such huge events actually
change our biology permanently

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00:07:13,000 --> 00:07:13,676
for years?

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00:07:13,676 --> 00:07:15,634
Or do you think that
there's a different reason

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00:07:15,634 --> 00:07:18,030
behind that sort of learning?

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00:07:18,030 --> 00:07:20,520
ANDREW LO: I'm saying
that it can change not so

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00:07:20,520 --> 00:07:22,620
much our biology,
but rather, it can

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00:07:22,620 --> 00:07:26,790
change our decision-making
abilities for years

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00:07:26,790 --> 00:07:30,090
to come, in the same way that
you know your grandmother

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00:07:30,090 --> 00:07:33,630
or great-grandmother
was indelibly affected

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00:07:33,630 --> 00:07:35,520
by living through
the Great Depression,

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00:07:35,520 --> 00:07:38,580
or through the Holocaust, or
through some extraordinary

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emotional trauma,
in the same way

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we will be affected by these
sets of circumstances for years

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00:07:45,780 --> 00:07:47,541
to come.

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Right?

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That's it.

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Ingrid.

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00:07:50,116 --> 00:07:52,685
AUDIENCE: I was really
impressed about two weeks ago

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00:07:52,685 --> 00:07:57,480
that I heard the different
networks, the channel

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00:07:57,480 --> 00:08:01,355
lists trying to convince people
not to getting them to buy

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00:08:01,355 --> 00:08:03,480
Christmas presents,
and people are

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00:08:03,480 --> 00:08:06,300
going to complain because
they could not not

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00:08:06,300 --> 00:08:08,570
buy gifts to their kids.

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And where I come from,
if you don't have money,

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00:08:10,600 --> 00:08:12,016
you don't have
money [INAUDIBLE]..

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00:08:12,016 --> 00:08:17,505
So it was really surprising
to see how that consumption

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mindset was so, so strong here.

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ANDREW LO: That's right.

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And you know, that's a very
unusual mindset for the United

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00:08:23,790 --> 00:08:27,330
States, because we are the
land of consumers, right?

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00:08:27,330 --> 00:08:30,270
I mean, consumption is
what drives this economy,

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00:08:30,270 --> 00:08:31,309
for better or for worse.

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00:08:31,309 --> 00:08:33,600
You know, that is what has
made this country as wealthy

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as it has.

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And so, it is a very difficult
time when we actually

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00:08:38,400 --> 00:08:40,409
have to all pull back.

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And you know there are some
individuals that would argue

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00:08:42,900 --> 00:08:44,459
that you shouldn't pull back.

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00:08:44,459 --> 00:08:46,500
You should keep on spending,
because if everybody

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00:08:46,500 --> 00:08:50,250
keeps on spending, then
somehow, magically, we will be,

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00:08:50,250 --> 00:08:51,770
stay richer.

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That doesn't quite work.

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There's an adding up
constraint somewhere.

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So wealth, if it's
lost, you know,

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00:08:58,020 --> 00:08:59,490
it's lost in a certain sense.

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00:08:59,490 --> 00:09:02,310
And you can't create
something out of nothing.

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00:09:02,310 --> 00:09:05,220
But I think there are some
issues about government's role

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00:09:05,220 --> 00:09:07,942
in being able to maintain a
certain degree of spending.

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00:09:07,942 --> 00:09:09,900
So we're going to get to
that in a few minutes.

191
00:09:09,900 --> 00:09:11,110
But you're absolutely right.

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00:09:11,110 --> 00:09:15,030
This is a very big change
from where we were just

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00:09:15,030 --> 00:09:17,830
even a few months ago.

194
00:09:17,830 --> 00:09:20,220
Other implications
of adaptive markets

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00:09:20,220 --> 00:09:24,210
is that limited arbitrage,
the so-called free lunches

196
00:09:24,210 --> 00:09:29,450
that we talked about, that
can exist from time to time.

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00:09:29,450 --> 00:09:32,060
There are free
lunches on occasion,

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00:09:32,060 --> 00:09:35,660
because you can think of the
free lunches as opportunities

199
00:09:35,660 --> 00:09:38,060
that a certain group of
individuals in the economy

200
00:09:38,060 --> 00:09:40,760
have identified
which may not last.

201
00:09:40,760 --> 00:09:43,400
And so over time, those
arbitrageurs end up

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00:09:43,400 --> 00:09:48,580
getting eaten away
by the arbitrageurs.

203
00:09:48,580 --> 00:09:52,090
But they still do exist
from time to time.

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00:09:52,090 --> 00:09:54,830
Free lunch programs
may not exist,

205
00:09:54,830 --> 00:09:57,880
in other words consistent
arbitrageurs time and again.

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00:09:57,880 --> 00:10:01,440
That is much, much more
difficult to come by.

207
00:10:01,440 --> 00:10:08,320
But as a result, strategies
will wax and wane

208
00:10:08,320 --> 00:10:09,730
through different cycles.

209
00:10:09,730 --> 00:10:13,240
And the way it does so
is exactly the same way

210
00:10:13,240 --> 00:10:18,580
that a beautiful, green
pasture can come and go

211
00:10:18,580 --> 00:10:21,310
based upon ecological dynamics.

212
00:10:21,310 --> 00:10:25,870
In particular, a green pasture
becomes a favorite spot

213
00:10:25,870 --> 00:10:28,840
for sheep to graze on.

214
00:10:28,840 --> 00:10:33,850
And after a while, as the sheep
graze and get fat and multiply,

215
00:10:33,850 --> 00:10:38,410
they have more and more
effect on that pasture.

216
00:10:38,410 --> 00:10:42,870
Pretty soon, with so many sheep
grazing on that same pasture,

217
00:10:42,870 --> 00:10:44,720
the pasture is depleted.

218
00:10:44,720 --> 00:10:46,320
And after it's
depleted, what happens

219
00:10:46,320 --> 00:10:48,070
to the sheep population?

220
00:10:48,070 --> 00:10:49,260
It declines.

221
00:10:49,260 --> 00:10:54,090
And the population declines,
the pasture grows back,

222
00:10:54,090 --> 00:10:56,250
and the cycle begins
all over again.

223
00:10:56,250 --> 00:10:57,870
Well, I have news for you.

224
00:10:57,870 --> 00:11:02,160
That pasture, you can
think of as profits.

225
00:11:02,160 --> 00:11:04,660
And the sheep, you can
think of as all of you.

226
00:11:04,660 --> 00:11:06,072
You're, the investors.

227
00:11:06,072 --> 00:11:08,280
And if it's profitable for
you to invest in something

228
00:11:08,280 --> 00:11:11,160
you will keep doing it,
and doing it, and doing it

229
00:11:11,160 --> 00:11:13,452
until there's no more pasture.

230
00:11:13,452 --> 00:11:15,660
That's what happened with
mortgage-backed securities.

231
00:11:15,660 --> 00:11:17,070
There's no more pasture now.

232
00:11:17,070 --> 00:11:18,222
It's pretty much gone.

233
00:11:18,222 --> 00:11:19,680
It's going to be
hard to make money

234
00:11:19,680 --> 00:11:21,240
in that market for a while.

235
00:11:21,240 --> 00:11:24,330
So all the sheep, they're
going to go away now.

236
00:11:24,330 --> 00:11:27,510
And over time, it
will come back.

237
00:11:27,510 --> 00:11:30,150
It may take a while,
but it will come back.

238
00:11:30,150 --> 00:11:31,770
And that's where
cycles come from.

239
00:11:31,770 --> 00:11:33,750
It's the exact same mechanism.

240
00:11:33,750 --> 00:11:35,940
This is not an
analogy or a metaphor.

241
00:11:35,940 --> 00:11:38,340
I'm describing
exactly the mechanism

242
00:11:38,340 --> 00:11:44,100
by which certain biological
entities interact

243
00:11:44,100 --> 00:11:45,660
with their environment.

244
00:11:45,660 --> 00:11:47,220
And we are biological entities.

245
00:11:47,220 --> 00:11:48,390
We're creatures.

246
00:11:48,390 --> 00:11:51,160
And we interact in
our environment.

247
00:11:51,160 --> 00:11:53,010
The only difference
between us and sheep

248
00:11:53,010 --> 00:11:55,680
is that we consume
dollars instead of grass.

249
00:11:55,680 --> 00:12:01,035
And so the dynamics are
really very much the same.

250
00:12:01,035 --> 00:12:02,910
And the bottom line, I
said, is that survival

251
00:12:02,910 --> 00:12:05,070
is all that matters.

252
00:12:05,070 --> 00:12:09,660
What any business cares about
in general is surviving.

253
00:12:09,660 --> 00:12:11,820
And as you push
for survival, a lot

254
00:12:11,820 --> 00:12:15,780
of the effects that you see in
typical evolutionary systems

255
00:12:15,780 --> 00:12:19,050
will emerge in economies.

256
00:12:19,050 --> 00:12:21,930
So let me talk specifically
about some very, very

257
00:12:21,930 --> 00:12:25,860
concrete examples of
these kinds of dynamics.

258
00:12:25,860 --> 00:12:27,910
I'll give you just a couple.

259
00:12:27,910 --> 00:12:30,030
The first example comes
from the hedge fund

260
00:12:30,030 --> 00:12:33,660
industry, and in particular,
from very, very simple--

261
00:12:33,660 --> 00:12:38,160
a simple observation about the
efficiency of the stock market.

262
00:12:38,160 --> 00:12:40,170
When we talked about the
random walk hypothesis

263
00:12:40,170 --> 00:12:42,210
a few weeks ago, we
mentioned that the idea

264
00:12:42,210 --> 00:12:46,170
behind the random walk
is that if prices fully

265
00:12:46,170 --> 00:12:49,136
reflect all available
information, then certainly,

266
00:12:49,136 --> 00:12:50,760
you shouldn't be able
to predict what's

267
00:12:50,760 --> 00:12:53,250
going to happen
to prices tomorrow

268
00:12:53,250 --> 00:12:56,700
based upon what happened
to prices last week, right?

269
00:12:56,700 --> 00:13:00,480
In other words, just because
we had a positive return

270
00:13:00,480 --> 00:13:03,660
over the last five days,
that positive return

271
00:13:03,660 --> 00:13:06,180
shouldn't give you
any hint as to whether

272
00:13:06,180 --> 00:13:09,120
or not the next five days
will be positive or negative,

273
00:13:09,120 --> 00:13:12,990
because all the information
of the last five days

274
00:13:12,990 --> 00:13:15,790
has been incorporated
into today's price.

275
00:13:15,790 --> 00:13:19,060
So at every point in
time, it's a fair game.

276
00:13:19,060 --> 00:13:21,220
It's a Martingale.

277
00:13:21,220 --> 00:13:23,680
Well if you believe
that, then what

278
00:13:23,680 --> 00:13:28,090
that says is that the
first-order autocorrelation

279
00:13:28,090 --> 00:13:31,810
of monthly stock returns
should be about zero.

280
00:13:31,810 --> 00:13:34,960
In other words, the correlation
between last month's return

281
00:13:34,960 --> 00:13:37,600
and this month's return
should be statistically

282
00:13:37,600 --> 00:13:40,030
indistinguishable from zero.

283
00:13:40,030 --> 00:13:42,070
Because if it weren't,
if it were strictly

284
00:13:42,070 --> 00:13:44,860
positive or negative, then
you'd have information

285
00:13:44,860 --> 00:13:48,340
to be able to base a
trading strategy on, right?

286
00:13:48,340 --> 00:13:49,930
For example, if
it were positive,

287
00:13:49,930 --> 00:13:51,681
then if last month's
return were positive,

288
00:13:51,681 --> 00:13:53,138
you can bet the
next month's return

289
00:13:53,138 --> 00:13:54,350
will continue to be positive.

290
00:13:54,350 --> 00:13:56,350
So you'll make a bigger
bet on the stock market.

291
00:13:56,350 --> 00:13:57,970
You'll develop a
trading strategy

292
00:13:57,970 --> 00:14:00,950
that can beat the market.

293
00:14:00,950 --> 00:14:05,720
Efficient markets hypothesis
would say you can't do that.

294
00:14:05,720 --> 00:14:08,540
You can't come up with these
kind of trading strategies.

295
00:14:08,540 --> 00:14:12,110
In other words, stock
prices follow random walks.

296
00:14:12,110 --> 00:14:14,360
Autocorrelation should be 0.

297
00:14:14,360 --> 00:14:16,010
All right, well,
let's take a look.

298
00:14:16,010 --> 00:14:20,450
This is the rolling
five-year serial correlation

299
00:14:20,450 --> 00:14:23,900
coefficient-- first-order
autocorrelation coefficient

300
00:14:23,900 --> 00:14:27,800
for stock returns on a
monthly basis for the S&P

301
00:14:27,800 --> 00:14:35,780
composite index from January
of 1871 to April of 2003.

302
00:14:35,780 --> 00:14:38,450
That's a lot of data, right?

303
00:14:38,450 --> 00:14:41,385
And if these are five-year
rolling window correlations--

304
00:14:41,385 --> 00:14:45,890
so every five years, I'm going
to calculate the correlation

305
00:14:45,890 --> 00:14:50,240
coefficient between month
T and month T minus 1,

306
00:14:50,240 --> 00:14:52,770
and it should be 0.

307
00:14:52,770 --> 00:14:55,180
But let's take a
look at what happens.

308
00:14:55,180 --> 00:14:57,850
In the 1800s, the
late 1800s, there

309
00:14:57,850 --> 00:15:01,330
was a fair bit of positive
correlation, correlation

310
00:15:01,330 --> 00:15:03,870
around 40% or 50%.

311
00:15:03,870 --> 00:15:06,070
And then, towards the
end of the century,

312
00:15:06,070 --> 00:15:08,250
the correlation goes
down, then it goes up.

313
00:15:08,250 --> 00:15:11,400
Then it goes way down
in the early 1900s.

314
00:15:11,400 --> 00:15:13,960
Then it goes up, then it
goes down, then it goes up.

315
00:15:13,960 --> 00:15:16,920
During the 1970s
here, there's a bit

316
00:15:16,920 --> 00:15:18,930
of a period where it goes
down, then it goes up,

317
00:15:18,930 --> 00:15:20,555
then it goes down,
then it goes way up.

318
00:15:20,555 --> 00:15:22,560
It shoots way up in the 1990s.

319
00:15:22,560 --> 00:15:25,830
And then, since the 1990s,
it's been relatively low.

320
00:15:25,830 --> 00:15:28,590
And actually, if you extended
it to the last few years,

321
00:15:28,590 --> 00:15:33,170
you'd see that it's
still pretty low.

322
00:15:33,170 --> 00:15:37,030
This diagram shows
that market efficiency,

323
00:15:37,030 --> 00:15:40,360
as measured by the first-order
autocorrelation first of all,

324
00:15:40,360 --> 00:15:41,620
it's not zero.

325
00:15:41,620 --> 00:15:45,670
But more importantly, it does
not decline monotonically

326
00:15:45,670 --> 00:15:46,280
over time.

327
00:15:46,280 --> 00:15:50,940
Markets are not getting more
and more and more efficient.

328
00:15:50,940 --> 00:15:52,410
There's a cycle of efficiency.

329
00:15:52,410 --> 00:15:55,700
There are periods where the
market is very efficient.

330
00:15:55,700 --> 00:15:58,220
And there are periods
where it's not.

331
00:15:58,220 --> 00:16:02,990
And these periods are
determined by the population

332
00:16:02,990 --> 00:16:06,560
of investors that are
interacting with each other.

333
00:16:06,560 --> 00:16:09,650
There are periods where markets
are extremely efficient,

334
00:16:09,650 --> 00:16:12,080
because you've got very
sophisticated investors

335
00:16:12,080 --> 00:16:14,480
in the market.

336
00:16:14,480 --> 00:16:17,540
But during the 1990s,
that wasn't one of them,

337
00:16:17,540 --> 00:16:19,970
because what was happening
during the 1990s?

338
00:16:19,970 --> 00:16:21,140
Who was trading here?

339
00:16:21,140 --> 00:16:21,770
Anybody know?

340
00:16:24,970 --> 00:16:26,890
Who?

341
00:16:26,890 --> 00:16:27,640
Tech.

342
00:16:27,640 --> 00:16:29,400
But who were the traders?

343
00:16:29,400 --> 00:16:30,400
AUDIENCE: Everybody was.

344
00:16:30,400 --> 00:16:31,191
ANDREW LO: Exactly.

345
00:16:31,191 --> 00:16:33,280
Retail investors, everybody.

346
00:16:33,280 --> 00:16:36,190
You know, the librarian,
the pharmacist, mom and pop,

347
00:16:36,190 --> 00:16:39,790
grandma, they were all
trading on E-trade on all

348
00:16:39,790 --> 00:16:43,030
of these various
different trading sites.

349
00:16:43,030 --> 00:16:46,895
And as a result, the market
became relatively inefficient.

350
00:16:46,895 --> 00:16:47,770
And you can see this.

351
00:16:47,770 --> 00:16:49,870
You can see this
as clear as day.

352
00:16:49,870 --> 00:16:52,630
By the way, right
around here was

353
00:16:52,630 --> 00:16:56,530
where some of the equity market
neutral hedge funds, like DE

354
00:16:56,530 --> 00:17:01,020
Shaw decided to go into
business and made a lot of money

355
00:17:01,020 --> 00:17:02,950
in this period.

356
00:17:02,950 --> 00:17:05,740
It's gotten a lot
harder now, no doubt.

357
00:17:05,740 --> 00:17:09,790
But my guess is that
over the next few years,

358
00:17:09,790 --> 00:17:13,960
you may see markets
becoming more inefficient.

359
00:17:13,960 --> 00:17:15,369
Why is that?

360
00:17:15,369 --> 00:17:18,339
Why might that be over
the next couple of years?

361
00:17:18,339 --> 00:17:19,511
Any guesses?

362
00:17:19,511 --> 00:17:20,260
Yeah, [INAUDIBLE]?

363
00:17:20,260 --> 00:17:21,849
AUDIENCE: Because people are
pulling out of the market?

364
00:17:21,849 --> 00:17:22,640
ANDREW LO: Exactly.

365
00:17:22,640 --> 00:17:25,420
People, particularly
sophisticated investors,

366
00:17:25,420 --> 00:17:27,670
like hedge funds, are
pulling out of the market

367
00:17:27,670 --> 00:17:29,050
because they're getting
blown out of the water.

368
00:17:29,050 --> 00:17:30,530
They're losing a lot of money.

369
00:17:30,530 --> 00:17:32,488
They don't have enough
to run their businesses.

370
00:17:32,488 --> 00:17:33,490
They're pulling out.

371
00:17:33,490 --> 00:17:39,190
And so whatever's left may not
be as efficient as it once was.

372
00:17:39,190 --> 00:17:41,260
That's adaptive markets.

373
00:17:41,260 --> 00:17:42,920
That's all.

374
00:17:42,920 --> 00:17:45,470
Economic systems are not
like physical systems.

375
00:17:45,470 --> 00:17:50,090
We're not approaching any
kind of steady state limit.

376
00:17:50,090 --> 00:17:51,777
We're interacting
with each other.

377
00:17:51,777 --> 00:17:53,360
And during certain
time periods, we're

378
00:17:53,360 --> 00:17:55,400
going to be very efficient.

379
00:17:55,400 --> 00:17:57,050
And then, by the
way, finance there

380
00:17:57,050 --> 00:17:59,080
is going to work quite well.

381
00:17:59,080 --> 00:18:01,360
But then there are going to
be periods that are crazy.

382
00:18:01,360 --> 00:18:04,810
And during those crazy
periods, market prices

383
00:18:04,810 --> 00:18:07,690
may not fully reflect all
available information,

384
00:18:07,690 --> 00:18:13,300
in which case, markets will
not be as reliable as finance

385
00:18:13,300 --> 00:18:14,950
theory makes them out to be.

386
00:18:14,950 --> 00:18:18,490
So when you apply
your 401 techniques,

387
00:18:18,490 --> 00:18:20,470
you've got to start by
asking the question,

388
00:18:20,470 --> 00:18:24,550
do those assumptions that
we made, do they hold?

389
00:18:24,550 --> 00:18:26,800
Is this a reasonable
period of time

390
00:18:26,800 --> 00:18:31,164
for which finance theory will
dictate what prices should be?

391
00:18:31,164 --> 00:18:32,108
[INAUDIBLE]

392
00:18:32,108 --> 00:18:34,940
AUDIENCE: If expected
return of the stock markets

393
00:18:34,940 --> 00:18:40,330
let's say 10%, then the other
correlation shouldn't be zero.

394
00:18:40,330 --> 00:18:42,254
It should be around--

395
00:18:42,254 --> 00:18:45,705
there's supposed to be some
correlation when the market is

396
00:18:45,705 --> 00:18:47,980
efficient is when the next--

397
00:18:47,980 --> 00:18:50,140
ANDREW LO: No, because
remember, the correlation

398
00:18:50,140 --> 00:18:55,080
is the covariance divided by the
variance in excess of the mean.

399
00:18:55,080 --> 00:18:57,360
These are deviations
from mean, right?

400
00:18:57,360 --> 00:19:01,020
So it doesn't matter if
it's 10%, or 20%, or 5%.

401
00:19:01,020 --> 00:19:02,910
If there's a trend,
the mean basically

402
00:19:02,910 --> 00:19:05,220
subtracts that trend off.

403
00:19:05,220 --> 00:19:06,705
Yes.

404
00:19:06,705 --> 00:19:10,486
AUDIENCE: There are a few
dips like, [INAUDIBLE]

405
00:19:10,486 --> 00:19:12,385
like [INAUDIBLE] does a dip.

406
00:19:12,385 --> 00:19:16,075
Like do you have an explanation
about like why that happened?

407
00:19:16,075 --> 00:19:18,430
ANDREW LO: Well,
the explanation,

408
00:19:18,430 --> 00:19:22,360
at least during the recent
periods, I have one for you.

409
00:19:22,360 --> 00:19:24,140
I don't know about
going back here.

410
00:19:24,140 --> 00:19:24,970
I can conjecture.

411
00:19:24,970 --> 00:19:26,428
But there are a
lot of other things

412
00:19:26,428 --> 00:19:30,010
going on here that I can't say
that I've really researched.

413
00:19:30,010 --> 00:19:32,420
But over here, I can
tell you what happened,

414
00:19:32,420 --> 00:19:34,540
which is that the
internet bubble burst.

415
00:19:34,540 --> 00:19:38,140
And then retail investors,
they left the market.

416
00:19:38,140 --> 00:19:41,650
And who was left but
sophisticated, institutional

417
00:19:41,650 --> 00:19:42,880
traders.

418
00:19:42,880 --> 00:19:45,970
And they took advantage
of whatever correlation

419
00:19:45,970 --> 00:19:46,660
there might be.

420
00:19:46,660 --> 00:19:49,720
And that basically bit
away any other profits

421
00:19:49,720 --> 00:19:51,280
that might have remained.

422
00:19:51,280 --> 00:19:55,690
So over the last, I don't know,
maybe five to eight years,

423
00:19:55,690 --> 00:19:59,620
long/short equity market
neutral and long/short equity

424
00:19:59,620 --> 00:20:01,540
strategies, that are
the basis for taking

425
00:20:01,540 --> 00:20:03,460
advantage of these
kind of correlations,

426
00:20:03,460 --> 00:20:04,880
have grown dramatically.

427
00:20:04,880 --> 00:20:08,020
And the profits have
declined significantly.

428
00:20:08,020 --> 00:20:10,710
Markets have gotten
more efficient.

429
00:20:10,710 --> 00:20:14,160
And you know, I would argue that
during certain periods of time,

430
00:20:14,160 --> 00:20:17,700
for example, during the
1950s, during this period,

431
00:20:17,700 --> 00:20:20,670
there were situations where
markets got more efficient

432
00:20:20,670 --> 00:20:24,090
because certain institutional
investors came in,

433
00:20:24,090 --> 00:20:26,310
and retail investors left.

434
00:20:26,310 --> 00:20:32,172
So by looking at the population
dynamics of the market ecology,

435
00:20:32,172 --> 00:20:34,130
you see, I mean, that
language that I just used

436
00:20:34,130 --> 00:20:37,010
is language that evolutionary
biologists would use.

437
00:20:37,010 --> 00:20:40,930
It's not something that
economists would ever say.

438
00:20:40,930 --> 00:20:43,390
How many of you actually heard
of an economist or the words

439
00:20:43,390 --> 00:20:45,070
that I just uttered?

440
00:20:45,070 --> 00:20:46,060
I don't think you have.

441
00:20:46,060 --> 00:20:48,250
You'll never hear it
in microeconomics,

442
00:20:48,250 --> 00:20:52,450
because microeconomic they
treat all consumers as the same.

443
00:20:52,450 --> 00:20:55,570
Maximize expected utility
subject to a budget constraint.

444
00:20:55,570 --> 00:20:57,440
Or they treat all
producers as the same.

445
00:20:57,440 --> 00:21:00,090
You can maximize profits
subject to a production function

446
00:21:00,090 --> 00:21:03,420
or resource constraint.

447
00:21:03,420 --> 00:21:05,760
What economists
don't recognize is

448
00:21:05,760 --> 00:21:07,320
that there are
different populations

449
00:21:07,320 --> 00:21:09,840
of consumers and producers.

450
00:21:09,840 --> 00:21:13,780
And these populations
arise in different ways.

451
00:21:13,780 --> 00:21:15,000
They're different species.

452
00:21:15,000 --> 00:21:18,370
And different species have
different characteristics.

453
00:21:18,370 --> 00:21:20,730
And so by studying
the different species,

454
00:21:20,730 --> 00:21:22,860
you will come up with
different insights.

455
00:21:22,860 --> 00:21:25,830
But the reason that we don't
have very many insights yet

456
00:21:25,830 --> 00:21:28,290
is because we don't even
speak in these terms.

457
00:21:28,290 --> 00:21:31,570
And therefore, we don't
measure the data in this way.

458
00:21:31,570 --> 00:21:34,390
For example, if I
wanted to today,

459
00:21:34,390 --> 00:21:39,330
the number of retail investors
versus institutional investors

460
00:21:39,330 --> 00:21:41,490
versus broker dealers
versus hedge funds--

461
00:21:41,490 --> 00:21:46,160
if I want to know the biomass
of the different species,

462
00:21:46,160 --> 00:21:48,140
I wouldn't know where to look.

463
00:21:48,140 --> 00:21:50,680
There's no database that has
this information, because we're

464
00:21:50,680 --> 00:21:51,550
not collecting it.

465
00:21:51,550 --> 00:21:53,740
We don't even collect
the information

466
00:21:53,740 --> 00:21:56,470
in the way that would be the
most amenable for analysis

467
00:21:56,470 --> 00:21:58,370
because this is such
a new framework.

468
00:21:58,370 --> 00:22:00,730
So you've got to have the
framework first to figure out

469
00:22:00,730 --> 00:22:02,938
what questions you want to
ask and what data you want

470
00:22:02,938 --> 00:22:06,650
to collect. , And ultimately
after you do that, over time,

471
00:22:06,650 --> 00:22:09,250
you'll be able to see these
kind of patterns emerging.

472
00:22:09,250 --> 00:22:10,805
Yeah, question.

473
00:22:10,805 --> 00:22:12,745
AUDIENCE: [INAUDIBLE]
contradicts

474
00:22:12,745 --> 00:22:18,014
the view of market
and the [INAUDIBLE]

475
00:22:18,014 --> 00:22:20,424
of market and permits
that say [INAUDIBLE]

476
00:22:20,424 --> 00:22:23,320
market the more [INAUDIBLE]
the more [INAUDIBLE]

477
00:22:23,320 --> 00:22:24,820
ANDREW LO: Absolutely.

478
00:22:24,820 --> 00:22:27,100
Absolutely, it does
contradict that.

479
00:22:27,100 --> 00:22:31,480
Yeah, this is why I leave this
material to the last lecture,

480
00:22:31,480 --> 00:22:35,410
because, you know, I feel
that it's inappropriate for me

481
00:22:35,410 --> 00:22:38,530
to spend an entire course
in Introductory finance

482
00:22:38,530 --> 00:22:41,500
teaching you what my pet
theories are as opposed

483
00:22:41,500 --> 00:22:42,460
to the mainstream.

484
00:22:42,460 --> 00:22:44,440
You need to know the
basics of what's out there

485
00:22:44,440 --> 00:22:46,300
and how people use the tools.

486
00:22:46,300 --> 00:22:48,230
So that's what we did
for 90% of the course.

487
00:22:48,230 --> 00:22:50,710
But I also would
feel it inappropriate

488
00:22:50,710 --> 00:22:52,662
for me to perpetuate
certain myths

489
00:22:52,662 --> 00:22:55,120
and let you leave this class
without at least understanding

490
00:22:55,120 --> 00:22:57,250
that there's a debate
going on, and that there's

491
00:22:57,250 --> 00:23:01,594
some uncertainty about exactly
what theories apply when.

492
00:23:01,594 --> 00:23:02,260
So you're right.

493
00:23:02,260 --> 00:23:04,940
This does contradict
the conventional wisdom.

494
00:23:04,940 --> 00:23:05,440
Yeah.

495
00:23:05,440 --> 00:23:08,158
AUDIENCE: All right,
[INAUDIBLE] correctly,

496
00:23:08,158 --> 00:23:13,215
the points of [INAUDIBLE]
rational investors.

497
00:23:13,215 --> 00:23:14,952
So right now,
[INAUDIBLE] market.

498
00:23:14,952 --> 00:23:15,924
What's wrong with that?

499
00:23:15,924 --> 00:23:18,840
I mean, after all, we're on a
path to an ineffecient market

500
00:23:18,840 --> 00:23:20,310
again, right?

501
00:23:20,310 --> 00:23:22,810
ANDREW LO: There's nothing
wrong with any of this.

502
00:23:22,810 --> 00:23:25,570
You know, you have to keep
in mind that I'm not making

503
00:23:25,570 --> 00:23:27,190
any value judgments whatsoever.

504
00:23:27,190 --> 00:23:29,901
What I'm trying to explain
to you is a way of thinking,

505
00:23:29,901 --> 00:23:30,400
right?

506
00:23:30,400 --> 00:23:33,130
So I'm trying to give
you a way to reconcile

507
00:23:33,130 --> 00:23:35,230
the various different
kinds of market theories

508
00:23:35,230 --> 00:23:39,190
that have been proposed, the
behavioral versus the rational.

509
00:23:39,190 --> 00:23:41,620
And what I'm arguing is that
neither of these theories

510
00:23:41,620 --> 00:23:43,390
are complete.

511
00:23:43,390 --> 00:23:46,330
They each focus on one
aspect of the market

512
00:23:46,330 --> 00:23:48,820
during one period of time.

513
00:23:48,820 --> 00:23:51,340
And what you need to
do in order to put it

514
00:23:51,340 --> 00:23:55,660
all together is to develop
a super theory that

515
00:23:55,660 --> 00:24:00,280
allows you to understand how
both of these subtheories

516
00:24:00,280 --> 00:24:02,300
are integrated with each other.

517
00:24:02,300 --> 00:24:04,287
And I think this
is what it does.

518
00:24:04,287 --> 00:24:04,786
OK?

519
00:24:04,786 --> 00:24:11,904
AUDIENCE: [INAUDIBLE] had
said that, [INAUDIBLE]

520
00:24:11,904 --> 00:24:15,225
show us pretty much has
a problem, because hedge

521
00:24:15,225 --> 00:24:18,052
funds are pretty much pulling
out as a result [INAUDIBLE]

522
00:24:18,052 --> 00:24:20,260
ANDREW LO: Yeah, but there's
nothing wrong with that.

523
00:24:20,260 --> 00:24:21,426
Hedge funds are pulling out.

524
00:24:21,426 --> 00:24:23,260
And markets will
become less efficient

525
00:24:23,260 --> 00:24:25,756
over the next couple of years.

526
00:24:25,756 --> 00:24:28,550
AUDIENCE: I think it'll be more
efficient, because people that

527
00:24:28,550 --> 00:24:31,671
have [INAUDIBLE] market, right?

528
00:24:31,671 --> 00:24:32,170
So--

529
00:24:32,170 --> 00:24:33,753
ANDREW LO: That
depends on who's left.

530
00:24:33,753 --> 00:24:35,950
That depends on who's
left in the market.

531
00:24:35,950 --> 00:24:39,070
If it's institutional investors
and other sophisticated

532
00:24:39,070 --> 00:24:40,810
investors, you may be right.

533
00:24:40,810 --> 00:24:42,580
But I would argue
that there are going

534
00:24:42,580 --> 00:24:45,070
to be regular investors, like
you and me, that are going

535
00:24:45,070 --> 00:24:46,150
to be left in the marketplace.

536
00:24:46,150 --> 00:24:47,941
And we're going to be
running for the hills

537
00:24:47,941 --> 00:24:51,220
or running for the big returns.

538
00:24:51,220 --> 00:24:53,440
And that's going to be
what drives the market

539
00:24:53,440 --> 00:24:55,450
for the next year or two.

540
00:24:55,450 --> 00:24:56,150
OK?

541
00:24:56,150 --> 00:24:58,400
That's going to be different
than the other periods

542
00:24:58,400 --> 00:25:00,380
where you see
inefficiencies occur,

543
00:25:00,380 --> 00:25:02,480
because the smart
money stayed in,

544
00:25:02,480 --> 00:25:03,882
and the dumb money pulled out.

545
00:25:03,882 --> 00:25:05,090
I shouldn't say "dumb money".

546
00:25:05,090 --> 00:25:07,200
That's kind of value judgment.

547
00:25:07,200 --> 00:25:10,250
The naive money, the
inexperienced money,

548
00:25:10,250 --> 00:25:12,440
the retail investors--

549
00:25:12,440 --> 00:25:16,110
they're the ones that
pulled out, you know, here.

550
00:25:16,110 --> 00:25:19,220
And so here, you had
tremendous amounts

551
00:25:19,220 --> 00:25:21,200
of retail money being applied.

552
00:25:21,200 --> 00:25:23,270
But retail investors,
they ended up

553
00:25:23,270 --> 00:25:26,420
losing a fair bit of
money going forward.

554
00:25:26,420 --> 00:25:29,120
And what was left here
is the hedge fund money.

555
00:25:29,120 --> 00:25:31,820
What I'm arguing is going to
happen over the next year, what

556
00:25:31,820 --> 00:25:33,770
has already happened
over the last year,

557
00:25:33,770 --> 00:25:37,270
is that hedge funds have pulled
out a lot of their money.

558
00:25:37,270 --> 00:25:38,490
So who's left?

559
00:25:38,490 --> 00:25:40,170
Ask yourself, who's left?

560
00:25:40,170 --> 00:25:42,030
When you think about
analyzing a market,

561
00:25:42,030 --> 00:25:44,465
don't just look at it as a
mathematical object and say,

562
00:25:44,465 --> 00:25:45,840
I'm going to write
down the CAPM,

563
00:25:45,840 --> 00:25:47,549
and this is what is
going to tell me.

564
00:25:47,549 --> 00:25:49,590
If you do that, you're
thinking like a physicist,

565
00:25:49,590 --> 00:25:50,830
not like a biologist.

566
00:25:50,830 --> 00:25:53,370
A biologist would say,
what are the species that

567
00:25:53,370 --> 00:25:55,180
are here in this ecology?

568
00:25:55,180 --> 00:25:57,330
And once you tell me
that, I'll tell you

569
00:25:57,330 --> 00:26:01,260
what things are going to happen
over the next year or two.

570
00:26:01,260 --> 00:26:06,050
So let me go to
now how all of this

571
00:26:06,050 --> 00:26:08,874
applies to the current crisis.

572
00:26:08,874 --> 00:26:10,790
I'm not going to talk
about the details of it.

573
00:26:10,790 --> 00:26:12,020
We've already spent
a fair bit of time

574
00:26:12,020 --> 00:26:13,820
this semester talking
about the crisis,

575
00:26:13,820 --> 00:26:16,580
talking about subprime
mortgages, securitization,

576
00:26:16,580 --> 00:26:18,590
the role of all of the
various different folks

577
00:26:18,590 --> 00:26:20,360
that were participating.

578
00:26:20,360 --> 00:26:23,540
But I want to make the following
point based upon the material

579
00:26:23,540 --> 00:26:25,970
that we covered last time.

580
00:26:25,970 --> 00:26:33,050
And that is the fact
that pain protects.

581
00:26:33,050 --> 00:26:36,830
This is a very important,
but rather obvious

582
00:26:36,830 --> 00:26:40,970
point, that I suspect many
of you may have overlooked.

583
00:26:40,970 --> 00:26:43,670
And let me just describe to
you a very simple illustration

584
00:26:43,670 --> 00:26:44,770
of it.

585
00:26:44,770 --> 00:26:47,270
Have any of you
run across people

586
00:26:47,270 --> 00:26:50,270
that have had like
temporary nerve damage?

587
00:26:50,270 --> 00:26:53,840
You know, their arm goes
numb for whatever reason.

588
00:26:53,840 --> 00:26:56,394
Anybody see what
happens to that arm,

589
00:26:56,394 --> 00:26:58,310
you know, over the course
of a couple of weeks

590
00:26:58,310 --> 00:27:01,400
after the nerve damage sets in?

591
00:27:01,400 --> 00:27:03,400
Anybody know?

592
00:27:03,400 --> 00:27:05,560
You have seen situations
where that happens?

593
00:27:05,560 --> 00:27:06,060
Yeah, Mike.

594
00:27:06,060 --> 00:27:07,050
AUDIENCE: I was going
to say, somewhere

595
00:27:07,050 --> 00:27:09,300
there was a little girl who
couldn't feel pain at all.

596
00:27:09,300 --> 00:27:11,531
And she had the-- she
kept clawing her eyes out.

597
00:27:11,531 --> 00:27:14,530
And she was completely
bruised because she just

598
00:27:14,530 --> 00:27:15,760
bumped into everything.

599
00:27:15,760 --> 00:27:17,182
ANDREW LO: That's right.

600
00:27:17,182 --> 00:27:17,890
It's interesting.

601
00:27:17,890 --> 00:27:20,050
When you see these
individuals, they

602
00:27:20,050 --> 00:27:24,940
look like they've been in
a cat fight with a tiger.

603
00:27:24,940 --> 00:27:27,340
You know, they're scratched,
bruised, you know,

604
00:27:27,340 --> 00:27:29,311
they've got these
incredible wounds.

605
00:27:29,311 --> 00:27:31,060
And you ask them, you
know, what happened?

606
00:27:31,060 --> 00:27:31,851
Did you get mugged?

607
00:27:31,851 --> 00:27:33,890
Did you get beaten up?

608
00:27:33,890 --> 00:27:35,300
And they'll say no.

609
00:27:35,300 --> 00:27:38,360
It's just walking around.

610
00:27:38,360 --> 00:27:43,600
It turns out that if you
can't feel in your left arm,

611
00:27:43,600 --> 00:27:49,350
if it's numb, then you
won't know to pull away

612
00:27:49,350 --> 00:27:54,460
when you scrape it on the
edge of a sharp chair,

613
00:27:54,460 --> 00:27:58,840
or you get pricked
by some kind of tool.

614
00:27:58,840 --> 00:28:00,160
You won't know to pull back.

615
00:28:00,160 --> 00:28:01,660
You might just keep
pushing forward.

616
00:28:01,660 --> 00:28:05,020
And you know, there goes
a scratch, and a cut,

617
00:28:05,020 --> 00:28:06,760
and a puncture.

618
00:28:06,760 --> 00:28:12,300
If you can't feel pain,
you can't protect yourself.

619
00:28:12,300 --> 00:28:14,820
Pain protects.

620
00:28:14,820 --> 00:28:19,630
If you think about any kind
of measure you have ever taken

621
00:28:19,630 --> 00:28:22,420
that has protected you,
whether it's pulling money out

622
00:28:22,420 --> 00:28:25,540
of the stock market, whether
it's getting out of a burning

623
00:28:25,540 --> 00:28:29,560
house, whether it's avoiding a
certain situation because you

624
00:28:29,560 --> 00:28:32,740
know that it would likely
turn into a very bad accident,

625
00:28:32,740 --> 00:28:37,440
like driving after you've
had too much to drink--

626
00:28:37,440 --> 00:28:42,120
if you've ever done anything
that involves pulling back

627
00:28:42,120 --> 00:28:45,660
from taking a risk,
it's because you have

628
00:28:45,660 --> 00:28:48,400
felt pain, either current pain.

629
00:28:48,400 --> 00:28:55,140
Or you have felt the
memory of previous pain.

630
00:28:55,140 --> 00:28:57,450
Now let me ask you a question.

631
00:28:57,450 --> 00:29:02,860
Suppose none of you
are feeling any pain.

632
00:29:02,860 --> 00:29:05,300
Will you actually be
able to control yourself

633
00:29:05,300 --> 00:29:08,330
from taking on certain risks?

634
00:29:08,330 --> 00:29:12,970
So this gets back to the
crisis that we're in right now.

635
00:29:12,970 --> 00:29:16,720
If in 2004 or 2005,
you were at one

636
00:29:16,720 --> 00:29:18,760
of these financial
institutions that

637
00:29:18,760 --> 00:29:21,210
invested in these
kinds of securities

638
00:29:21,210 --> 00:29:23,380
or these strategies--
and not everyone did.

639
00:29:23,380 --> 00:29:27,520
So I don't mean to make a
sweeping generalization.

640
00:29:27,520 --> 00:29:29,680
But a number of very
large institutions

641
00:29:29,680 --> 00:29:31,720
seem to have
overextended themselves.

642
00:29:34,760 --> 00:29:37,730
What I want to argue
is that this is not

643
00:29:37,730 --> 00:29:42,710
something that is very easily
preventable unless we impose

644
00:29:42,710 --> 00:29:49,130
certain restrictions in advance,
unless we decide before we ever

645
00:29:49,130 --> 00:29:53,960
enter that situation that we're
not going to do something,

646
00:29:53,960 --> 00:29:58,460
because otherwise it's going to
be impossible for us to avoid

647
00:29:58,460 --> 00:30:03,080
doing it when it feels so
good, when we are in no pain.

648
00:30:03,080 --> 00:30:05,150
I want to be even more specific.

649
00:30:05,150 --> 00:30:10,970
It turns out that financial
gain, monetary reward,

650
00:30:10,970 --> 00:30:13,610
actually stimulates
the same reward

651
00:30:13,610 --> 00:30:17,720
circuitry that cocaine does.

652
00:30:17,720 --> 00:30:18,620
I'm not kidding.

653
00:30:18,620 --> 00:30:20,760
This is not an
analogy or a metaphor.

654
00:30:20,760 --> 00:30:22,430
It's a physiological fact.

655
00:30:22,430 --> 00:30:25,190
Neuroscientists
using fMRI machines

656
00:30:25,190 --> 00:30:29,330
had individuals play games
involving real money--

657
00:30:29,330 --> 00:30:33,320
not a lot of money, but enough
so that it actually registered.

658
00:30:33,320 --> 00:30:38,290
And it turns out that they found
that when people made money

659
00:30:38,290 --> 00:30:45,550
in the MRI machine, that
their brain released dopamine

660
00:30:45,550 --> 00:30:49,180
into a region of the brain
called the nucleus accumbens.

661
00:30:49,180 --> 00:30:51,010
This is exactly
the same thing that

662
00:30:51,010 --> 00:30:54,400
happens when you take cocaine.

663
00:30:54,400 --> 00:30:56,160
Some people have said
that making money

664
00:30:56,160 --> 00:30:58,080
is better than sex.

665
00:30:58,080 --> 00:30:58,840
You know what?

666
00:30:58,840 --> 00:31:02,250
That's actually not
an exaggeration.

667
00:31:02,250 --> 00:31:06,340
It stimulates the same
kind of neural circuitry.

668
00:31:06,340 --> 00:31:10,930
And when you are in this
kind of a mode of reaction,

669
00:31:10,930 --> 00:31:14,230
when your nucleus accumbens
is being hyperstimulated

670
00:31:14,230 --> 00:31:20,010
by dopamine, it will be very
hard, almost impossible for you

671
00:31:20,010 --> 00:31:22,590
to pull back and say, no.

672
00:31:22,590 --> 00:31:24,030
I don't want to.

673
00:31:24,030 --> 00:31:26,310
That's what an
addiction is, frankly.

674
00:31:26,310 --> 00:31:29,220
And for extended
periods of prosperity,

675
00:31:29,220 --> 00:31:32,580
which we have had over
the last 10 years,

676
00:31:32,580 --> 00:31:34,530
it's become
virtually impossible.

677
00:31:34,530 --> 00:31:35,760
I'm not condoning it.

678
00:31:35,760 --> 00:31:36,700
Don't get me wrong.

679
00:31:36,700 --> 00:31:40,240
I'm not arguing that these
excesses are just fine

680
00:31:40,240 --> 00:31:41,430
and we excuse them.

681
00:31:41,430 --> 00:31:43,290
I'm actually explaining
a biological fact

682
00:31:43,290 --> 00:31:45,540
about how all of
us are hardwired.

683
00:31:45,540 --> 00:31:50,730
When we're making money, it's
very hard for us to pull back--

684
00:31:50,730 --> 00:31:56,520
so much so, that as a
society, it is possible for us

685
00:31:56,520 --> 00:31:59,640
to overextend ourselves.

686
00:31:59,640 --> 00:32:05,260
And this actually is one role
that regulation can play.

687
00:32:05,260 --> 00:32:07,260
You know, economists have
argued that government

688
00:32:07,260 --> 00:32:10,380
should be involved because
we have public goods.

689
00:32:10,380 --> 00:32:11,520
We have externalities.

690
00:32:11,520 --> 00:32:13,027
We have incomplete markets.

691
00:32:13,027 --> 00:32:15,360
But I think that economists
have missed the most obvious

692
00:32:15,360 --> 00:32:19,650
motivation for regulation,
which is regulation

693
00:32:19,650 --> 00:32:23,310
is a means by which
society prevents itself

694
00:32:23,310 --> 00:32:26,820
from doing the things that it
knows it doesn't want to do

695
00:32:26,820 --> 00:32:30,090
during those periods where it
is incapable of stopping itself

696
00:32:30,090 --> 00:32:31,181
from doing it.

697
00:32:31,181 --> 00:32:31,680
Right?

698
00:32:31,680 --> 00:32:33,780
This is why some people
put their potato chips

699
00:32:33,780 --> 00:32:35,759
on the very top shell
in their kitchen.

700
00:32:35,759 --> 00:32:37,800
They know that they
shouldn't be having too many.

701
00:32:37,800 --> 00:32:40,920
So they make it harder to get
it so that when they get it,

702
00:32:40,920 --> 00:32:43,010
you know, it provides
some kind of distance.

703
00:32:43,010 --> 00:32:44,260
And that doesn't work so well.

704
00:32:44,260 --> 00:32:46,510
I can attest to that.

705
00:32:46,510 --> 00:32:47,910
But I'll give you
another example

706
00:32:47,910 --> 00:32:49,409
I'll give you another
example that's

707
00:32:49,409 --> 00:32:51,420
a little bit more direct.

708
00:32:51,420 --> 00:32:54,000
In every state in
the United States,

709
00:32:54,000 --> 00:33:00,640
we impose fire codes on
builders, fire codes that

710
00:33:00,640 --> 00:33:04,240
require you to have a
minimum number of exits,

711
00:33:04,240 --> 00:33:08,350
to have well-lit exit
signs that you can see,

712
00:33:08,350 --> 00:33:11,080
to have visible fire
alarms, to have sprinkler

713
00:33:11,080 --> 00:33:12,220
systems in the ceiling.

714
00:33:12,220 --> 00:33:13,660
All of this stuff costs money.

715
00:33:13,660 --> 00:33:15,990
It's actually very
expensive to put it.

716
00:33:15,990 --> 00:33:18,480
Do you ever wonder
why we have those?

717
00:33:18,480 --> 00:33:21,330
In other words, why not
let the free market work?

718
00:33:21,330 --> 00:33:23,040
Let people be free to choose.

719
00:33:23,040 --> 00:33:24,750
Those of you that
are nervous Nellies

720
00:33:24,750 --> 00:33:26,820
that are worried
about a fire, you

721
00:33:26,820 --> 00:33:28,980
will simply pay
more for buildings

722
00:33:28,980 --> 00:33:31,200
that have all these goodies.

723
00:33:31,200 --> 00:33:33,360
And then we can
have other buildings

724
00:33:33,360 --> 00:33:35,730
that don't have any
of these protections.

725
00:33:35,730 --> 00:33:38,585
And let people be
free to choose.

726
00:33:38,585 --> 00:33:39,460
Why don't we do that?

727
00:33:39,460 --> 00:33:41,140
That's a perfect equilibrium
from an economist

728
00:33:41,140 --> 00:33:41,723
point of view.

729
00:33:41,723 --> 00:33:42,860
Well, you know why?

730
00:33:42,860 --> 00:33:46,530
It's because in that
free-to-choose world,

731
00:33:46,530 --> 00:33:49,239
none of you will choose the
more expensive building.

732
00:33:49,239 --> 00:33:50,280
And the reason is simple.

733
00:33:50,280 --> 00:33:53,550
It's because when you
assess the probability

734
00:33:53,550 --> 00:33:57,360
of a fire on any given day,
you put a weight of zero

735
00:33:57,360 --> 00:33:58,059
to that event.

736
00:33:58,059 --> 00:33:59,850
I don't any of you came
into this classroom

737
00:33:59,850 --> 00:34:01,710
today thinking hmm,
if there's a fire, who

738
00:34:01,710 --> 00:34:05,574
am I going to have to step
over to get out of that exit?

739
00:34:05,574 --> 00:34:06,990
Maybe you are
thinking about that.

740
00:34:06,990 --> 00:34:10,139
That's why you guys
are sitting here.

741
00:34:10,139 --> 00:34:12,840
But we don't think about
it, because it's not

742
00:34:12,840 --> 00:34:15,690
part of our cognitive
process to focus

743
00:34:15,690 --> 00:34:17,760
on every possible eventuality.

744
00:34:17,760 --> 00:34:22,750
We don't have an infinite
computing machine on our heads.

745
00:34:22,750 --> 00:34:27,949
So we assign certain
events zero probability.

746
00:34:27,949 --> 00:34:30,710
And when you do, you
will pay nothing for it.

747
00:34:30,710 --> 00:34:32,420
So there will be
nobody that will

748
00:34:32,420 --> 00:34:36,380
pay for sprinklers, in which
case, it won't get done.

749
00:34:36,380 --> 00:34:39,409
And as we know, when
it doesn't get done,

750
00:34:39,409 --> 00:34:41,210
eventually, you have a fire.

751
00:34:41,210 --> 00:34:45,710
And during that fire, you really
wish you had those sprinklers.

752
00:34:45,710 --> 00:34:48,510
And it'll be too late to
put them in at that time.

753
00:34:48,510 --> 00:34:49,610
So we regulate.

754
00:34:49,610 --> 00:34:52,429
We regulate because
we know ourselves.

755
00:34:52,429 --> 00:34:55,010
And we know that during
certain situations,

756
00:34:55,010 --> 00:34:59,430
we will not act in a way that
we would like ourselves to act.

757
00:34:59,430 --> 00:35:01,700
So we prevent ourselves
from doing that

758
00:35:01,700 --> 00:35:07,770
by developing these laws that
we just simply have to follow.

759
00:35:07,770 --> 00:35:11,850
Well, that can be done
as well for problems

760
00:35:11,850 --> 00:35:15,300
like leverage credit and so on.

761
00:35:15,300 --> 00:35:18,180
So the point is
that risk management

762
00:35:18,180 --> 00:35:23,790
doesn't work unless we are able
to experience pain and fear.

763
00:35:23,790 --> 00:35:28,350
And profits are a very
potent anesthetic.

764
00:35:28,350 --> 00:35:29,700
They're like a drug.

765
00:35:29,700 --> 00:35:32,160
And the more profit you have,
for a long enough period

766
00:35:32,160 --> 00:35:35,910
of time, you become a lot less
anxious about asking questions,

767
00:35:35,910 --> 00:35:38,130
because you're not
feeling any pain.

768
00:35:38,130 --> 00:35:41,100
You're not feeling pain, so you
won't ask the tough questions.

769
00:35:41,100 --> 00:35:43,230
And you won't scale
back the risks

770
00:35:43,230 --> 00:35:47,370
while everybody else seems
to be doing just fine.

771
00:35:47,370 --> 00:35:52,560
So the point is that
proper balance is the key.

772
00:35:52,560 --> 00:35:56,310
We have to have a proper
balance of fear, greed,

773
00:35:56,310 --> 00:35:58,320
and logical analysis.

774
00:35:58,320 --> 00:36:00,570
And if we know that
there are periods

775
00:36:00,570 --> 00:36:03,660
where that proper balance
will be out of kilter,

776
00:36:03,660 --> 00:36:08,540
that's the role that regulation
can play during those periods.

777
00:36:08,540 --> 00:36:10,120
OK?

778
00:36:10,120 --> 00:36:13,460
So what do we what do we
think about going forward?

779
00:36:13,460 --> 00:36:18,420
Well, clearly the
fear of the unknown

780
00:36:18,420 --> 00:36:20,820
magnifies the
problems that were in.

781
00:36:20,820 --> 00:36:23,910
Flight to liquidity
is likely to persist.

782
00:36:23,910 --> 00:36:26,190
And we really are
going to have to think

783
00:36:26,190 --> 00:36:29,760
more carefully about
developing better analytics.

784
00:36:29,760 --> 00:36:32,580
And ultimately, what
we're going to see over

785
00:36:32,580 --> 00:36:36,300
the next couple of years
is a tremendous period

786
00:36:36,300 --> 00:36:37,920
of innovation--

787
00:36:37,920 --> 00:36:40,680
some of it good, some of it bad.

788
00:36:40,680 --> 00:36:44,280
But we're going to use
the current situation

789
00:36:44,280 --> 00:36:49,230
to really improve and expand
the current infrastructure

790
00:36:49,230 --> 00:36:51,010
for the coming decades.

791
00:36:51,010 --> 00:36:55,500
So as one of the Obama
transition managers mentioned,

792
00:36:55,500 --> 00:36:57,870
a crisis is a terrible
thing to waste.

793
00:36:57,870 --> 00:37:01,950
The next year or two is a
golden opportunity for us

794
00:37:01,950 --> 00:37:04,770
to take advantage of
the crisis by motivating

795
00:37:04,770 --> 00:37:08,790
ourselves to change the
regulatory infrastructure.

796
00:37:08,790 --> 00:37:09,360
Right?

797
00:37:09,360 --> 00:37:11,820
If things are going
well, then there's

798
00:37:11,820 --> 00:37:14,100
no point in trying to
change anything, right?

799
00:37:14,100 --> 00:37:15,240
Don't mess with success.

800
00:37:15,240 --> 00:37:17,204
You've heard that before.

801
00:37:17,204 --> 00:37:18,620
The point is that
right now, we're

802
00:37:18,620 --> 00:37:21,170
in a situation where we can
actually change something.

803
00:37:21,170 --> 00:37:23,150
And so the adaptive
markets would tell us

804
00:37:23,150 --> 00:37:27,020
that this is our way of
creating that infrastructure

805
00:37:27,020 --> 00:37:30,910
to build for the coming growth.

806
00:37:30,910 --> 00:37:36,660
So in conclusion, I would argue
that finance and economics are

807
00:37:36,660 --> 00:37:39,000
a lot more like
evolutionary biology

808
00:37:39,000 --> 00:37:41,277
than they are like physics.

809
00:37:41,277 --> 00:37:43,860
We really have to take a look
at the evolutionary perspective.

810
00:37:43,860 --> 00:37:47,880
And the bottom line
is whether or not

811
00:37:47,880 --> 00:37:50,100
you are going to survive.

812
00:37:50,100 --> 00:37:51,920
That's what we all care about.

813
00:37:51,920 --> 00:37:54,750
That's what we
ultimately strive to do.

814
00:37:54,750 --> 00:37:57,870
And if you understand
this about markets,

815
00:37:57,870 --> 00:38:00,570
you'll have a much better
chance of surviving.

816
00:38:00,570 --> 00:38:03,090
So from the perspective
of 401, the material

817
00:38:03,090 --> 00:38:05,160
we've learned in
this course, we've

818
00:38:05,160 --> 00:38:10,240
gone over the rational
approach to analyzing value

819
00:38:10,240 --> 00:38:13,140
in various kinds of
market interactions.

820
00:38:13,140 --> 00:38:16,080
And just be aware that
for the most part,

821
00:38:16,080 --> 00:38:18,030
that may work reasonably well.

822
00:38:18,030 --> 00:38:22,350
But for extreme circumstances,
periods of extreme wealth,

823
00:38:22,350 --> 00:38:26,750
as well as periods of
extreme market distress,

824
00:38:26,750 --> 00:38:31,790
prices may not be in-line with
what our analytical framework

825
00:38:31,790 --> 00:38:32,360
suggests.

826
00:38:32,360 --> 00:38:34,970
And at that point, you
need to reassess and try

827
00:38:34,970 --> 00:38:36,990
to come up with alternatives.

828
00:38:36,990 --> 00:38:40,280
What those are, we
currently don't know.

829
00:38:40,280 --> 00:38:42,620
We don't have a
good theory for what

830
00:38:42,620 --> 00:38:45,920
happens when the traditional
analytics break down,

831
00:38:45,920 --> 00:38:47,960
because up until
recently, nobody

832
00:38:47,960 --> 00:38:49,490
would be even
willing to consider

833
00:38:49,490 --> 00:38:52,141
that the traditional analytics
would ever break down.

834
00:38:52,141 --> 00:38:52,640
OK?

835
00:38:52,640 --> 00:38:55,560
So this whole area
is relatively new.

836
00:38:55,560 --> 00:38:58,350
And as I mentioned, at the
beginning of this lecture,

837
00:38:58,350 --> 00:39:00,341
if you do a search
for adaptive markets,

838
00:39:00,341 --> 00:39:02,090
you're going to only
find my name attached

839
00:39:02,090 --> 00:39:03,050
to that at this point.

840
00:39:03,050 --> 00:39:06,710
It's not really a theory that's
come into even common parlance,

841
00:39:06,710 --> 00:39:08,960
never mind general acceptance.

842
00:39:08,960 --> 00:39:10,540
It's a conjecture at this point.

843
00:39:10,540 --> 00:39:14,850
It's an alternative to the
current received wisdom.

844
00:39:14,850 --> 00:39:18,200
But the hope is that over time,
as we understand more and more

845
00:39:18,200 --> 00:39:21,080
about these interactions, we'll
be able to develop alternative.

846
00:39:21,080 --> 00:39:23,900
So then, I'm hoping that
a few years from now,

847
00:39:23,900 --> 00:39:25,610
I will be able to
tell all of you,

848
00:39:25,610 --> 00:39:28,910
this is a theory for markets
when they are normal.

849
00:39:28,910 --> 00:39:32,150
And this is a theory for
markets under certain kinds

850
00:39:32,150 --> 00:39:33,500
of distress.

851
00:39:33,500 --> 00:39:37,250
And at that point, we will have
a complete theory of markets

852
00:39:37,250 --> 00:39:38,480
under all circumstances.

853
00:39:38,480 --> 00:39:40,388
But we're still a few
years away from that.

854
00:39:40,388 --> 00:39:41,264
[INAUDIBLE]

855
00:39:41,264 --> 00:39:44,445
AUDIENCE: There are a number
of economists the value

856
00:39:44,445 --> 00:39:47,330
that the financial
sector in the US

857
00:39:47,330 --> 00:39:50,920
was already among the
most regulated sectors.

858
00:39:50,920 --> 00:39:55,295
But partially these regulations
caused [INAUDIBLE] Fannie Mae

859
00:39:55,295 --> 00:39:56,740
and Freddie Mac.

860
00:39:56,740 --> 00:40:00,738
And so actually, I would
argue for the opposite.

861
00:40:00,738 --> 00:40:02,530
And do you think
that the regulation

862
00:40:02,530 --> 00:40:07,845
should be fixed because it's
wrong, or you should add more?

863
00:40:07,845 --> 00:40:10,820
ANDREW LO: Well, I don't
think we should add more.

864
00:40:10,820 --> 00:40:13,710
I would argue that we
don't need more regulation.

865
00:40:13,710 --> 00:40:16,500
We need better
regulation, smarter,

866
00:40:16,500 --> 00:40:18,770
more adaptive regulation.

867
00:40:18,770 --> 00:40:22,500
So to your point,
the banking sector,

868
00:40:22,500 --> 00:40:28,120
which is where the majority
of these problems sit today,

869
00:40:28,120 --> 00:40:31,000
the banking sector is
the most regulated sector

870
00:40:31,000 --> 00:40:34,390
of all in all of
the financial world.

871
00:40:34,390 --> 00:40:39,730
And the next most regulated
sector is the insurance sector.

872
00:40:39,730 --> 00:40:41,870
And you have
problems there, too.

873
00:40:41,870 --> 00:40:44,680
So on the one hand, you
could argue that gee,

874
00:40:44,680 --> 00:40:47,170
it's all this regulation
that's created it.

875
00:40:47,170 --> 00:40:49,000
I don't believe that either.

876
00:40:49,000 --> 00:40:51,760
And the reason is that
a lot of these problems

877
00:40:51,760 --> 00:40:57,790
started in 1999 and
after when we actually

878
00:40:57,790 --> 00:41:00,340
dismantled some
of the regulation,

879
00:41:00,340 --> 00:41:02,470
in particular the
Glass-Steagall Act.

880
00:41:02,470 --> 00:41:04,240
We dismantled that in 1999.

881
00:41:04,240 --> 00:41:06,910
And by the way, that wasn't
done by the Republicans.

882
00:41:06,910 --> 00:41:08,110
Bill Clinton signed that.

883
00:41:08,110 --> 00:41:11,670
So there's blame to share
across both political parties.

884
00:41:11,670 --> 00:41:15,510
This is not a political
problem, per say.

885
00:41:15,510 --> 00:41:17,310
So we reduced regulation.

886
00:41:17,310 --> 00:41:19,320
We allowed banks to be
more like hedge funds.

887
00:41:19,320 --> 00:41:22,200
We allowed hedge funds
to be more like banks.

888
00:41:22,200 --> 00:41:26,640
And we got ourselves into the
problem that we face today.

889
00:41:26,640 --> 00:41:28,200
So it's not more regulation.

890
00:41:28,200 --> 00:41:31,260
We have to be smarter about
what we're regulating.

891
00:41:31,260 --> 00:41:33,630
And that's what I'm
hoping that we will

892
00:41:33,630 --> 00:41:37,170
do over the next few years.

893
00:41:37,170 --> 00:41:40,220
OK, well, that's it.

894
00:41:40,220 --> 00:41:44,000
That's it for
Introductory Finance.

895
00:41:44,000 --> 00:41:48,600
What I want to do now in just
the last 15 or 20 minutes,

896
00:41:48,600 --> 00:41:50,944
I'm going to give you a
near-death experience,

897
00:41:50,944 --> 00:41:52,610
because you get to
see the entire course

898
00:41:52,610 --> 00:41:54,620
flash before your very eyes.

899
00:41:54,620 --> 00:41:58,340
I want to go over what
we've done to-date

900
00:41:58,340 --> 00:41:59,732
and try to make sense of it all.

901
00:41:59,732 --> 00:42:01,190
And then I'll tell
you a little bit

902
00:42:01,190 --> 00:42:07,030
about what you might be in store
for with classes in the future.

903
00:42:07,030 --> 00:42:11,570
So let's start at
the very beginning.

904
00:42:11,570 --> 00:42:15,470
I started with this motivation--
mathematics plus money

905
00:42:15,470 --> 00:42:16,400
is equal to finance.

906
00:42:16,400 --> 00:42:19,160
And I hope that I've
delivered on that.

907
00:42:19,160 --> 00:42:22,310
In other words, we've got
very different approaches

908
00:42:22,310 --> 00:42:23,510
to investments.

909
00:42:23,510 --> 00:42:25,940
At the one in the
spectrum, James Simons,

910
00:42:25,940 --> 00:42:29,060
at the other, Warren
Buffett, and, of course,

911
00:42:29,060 --> 00:42:31,430
Jack Welch in-between.

912
00:42:31,430 --> 00:42:35,090
And each of these individuals
brings unique skills

913
00:42:35,090 --> 00:42:37,550
and insights into the
investment process.

914
00:42:37,550 --> 00:42:39,810
And what we wanted
to do in this course,

915
00:42:39,810 --> 00:42:43,280
was to try to distill some
of the basic principles

916
00:42:43,280 --> 00:42:46,820
and the language of finance that
all three of these individuals

917
00:42:46,820 --> 00:42:48,740
would agree are
sort of the building

918
00:42:48,740 --> 00:42:52,070
blocks of understanding
market dynamics.

919
00:42:52,070 --> 00:42:54,650
And as we started
at the beginning

920
00:42:54,650 --> 00:42:56,840
with this flow model
of the economy,

921
00:42:56,840 --> 00:42:59,240
we said that we were going
to study four components--

922
00:42:59,240 --> 00:43:02,420
households, capital markets,
financial intermediaries,

923
00:43:02,420 --> 00:43:03,740
and non-financial corporations.

924
00:43:03,740 --> 00:43:07,560
That's the financial
system as we know it.

925
00:43:07,560 --> 00:43:11,570
And we began with those six
principles of modern finance.

926
00:43:11,570 --> 00:43:13,922
Now I think you have a
deeper appreciation for it.

927
00:43:13,922 --> 00:43:15,380
As I said, we were
only going to be

928
00:43:15,380 --> 00:43:18,260
able to focus on the first few.

929
00:43:18,260 --> 00:43:20,450
And the latter
principles were going

930
00:43:20,450 --> 00:43:22,700
to be underlying
much of the theories

931
00:43:22,700 --> 00:43:24,957
that you would study
beyond this course.

932
00:43:24,957 --> 00:43:26,540
There's no such thing
as a free lunch.

933
00:43:26,540 --> 00:43:30,450
That's a very basic principle
that we used time and again

934
00:43:30,450 --> 00:43:33,650
in coming up with various
different pricing implications.

935
00:43:33,650 --> 00:43:37,010
And P2 is the
behavioral assumption

936
00:43:37,010 --> 00:43:40,100
that I argued we need
for much of the theories

937
00:43:40,100 --> 00:43:41,280
that we developed.

938
00:43:41,280 --> 00:43:43,370
But what I just told
you in the last lecture

939
00:43:43,370 --> 00:43:45,830
is that there are
occasions where

940
00:43:45,830 --> 00:43:48,800
those behavioral
assumptions, ultimately,

941
00:43:48,800 --> 00:43:51,470
are suspended or
replaced with this kind

942
00:43:51,470 --> 00:43:54,110
of overwhelming
emotional component.

943
00:43:54,110 --> 00:43:55,790
We prefer more money
to less, prefer

944
00:43:55,790 --> 00:43:59,260
money now to money later,
and we prefer to avoid risk.

945
00:43:59,260 --> 00:44:02,570
P3-- all agents act to further
their own self-interest.

946
00:44:02,570 --> 00:44:03,970
That's pretty straightforward.

947
00:44:03,970 --> 00:44:06,080
P4-- financial
market prices shift

948
00:44:06,080 --> 00:44:08,510
to equate supply and demand.

949
00:44:08,510 --> 00:44:11,792
And then P5-- financial markets
highly adaptive-competitive,

950
00:44:11,792 --> 00:44:13,250
and that risk-sharing
and frictions

951
00:44:13,250 --> 00:44:15,620
are central to
financial innovation.

952
00:44:15,620 --> 00:44:17,540
I hope that throughout
the entire course

953
00:44:17,540 --> 00:44:20,930
you've got an appreciation for
all six of these principles.

954
00:44:20,930 --> 00:44:25,160
It's remarkable how such
relatively simple ideas

955
00:44:25,160 --> 00:44:28,130
can have such dramatic
implications as we've developed

956
00:44:28,130 --> 00:44:30,690
over the last 13 weeks.

957
00:44:30,690 --> 00:44:33,280
OK so there are four
sections that we focused

958
00:44:33,280 --> 00:44:36,070
on-- the introduction,
evaluation, risk,

959
00:44:36,070 --> 00:44:37,420
and corporate finance.

960
00:44:37,420 --> 00:44:40,780
And then the final lecture of
"Try to put it all together."

961
00:44:40,780 --> 00:44:44,170
For present value,
the focus really

962
00:44:44,170 --> 00:44:47,530
was defining what an asset is--
a package, a sequence of cash

963
00:44:47,530 --> 00:44:50,620
flows, and the time
value of money,

964
00:44:50,620 --> 00:44:53,530
looking at present value
versus future value,

965
00:44:53,530 --> 00:44:57,830
and focusing on exchange
rates between today, tomorrow,

966
00:44:57,830 --> 00:44:58,600
and other dates.

967
00:44:58,600 --> 00:45:00,610
That was sort of
the key insight.

968
00:45:00,610 --> 00:45:04,900
And once you understand how
to visualize the cash flows

969
00:45:04,900 --> 00:45:09,670
and move money through time, you
understand a very significant

970
00:45:09,670 --> 00:45:12,421
portion of financial analysis.

971
00:45:12,421 --> 00:45:14,170
And then we talked
about some special cash

972
00:45:14,170 --> 00:45:16,000
flows-- perpetuities
and annuities,

973
00:45:16,000 --> 00:45:18,190
which we use for virtually
everything in terms

974
00:45:18,190 --> 00:45:18,910
of valuation.

975
00:45:18,910 --> 00:45:20,830
Very important ideas.

976
00:45:20,830 --> 00:45:24,310
And then we talked a bit about
compounding and inflation.

977
00:45:24,310 --> 00:45:26,200
Fixed-income
securities-- Well, we

978
00:45:26,200 --> 00:45:29,080
talked about applying the
very basic mathematics

979
00:45:29,080 --> 00:45:33,520
of present value to these
pure discount bonds and coupon

980
00:45:33,520 --> 00:45:34,625
bonds.

981
00:45:34,625 --> 00:45:37,000
The relationship between coupon
bonds and discount bonds,

982
00:45:37,000 --> 00:45:40,150
of course, is through arbitrage.

983
00:45:40,150 --> 00:45:42,940
And we also found that
current bond prices

984
00:45:42,940 --> 00:45:45,190
contain enormous
amounts of information

985
00:45:45,190 --> 00:45:47,900
about what's going to
happen in the future.

986
00:45:47,900 --> 00:45:49,650
We talked about spot
rates, forward rates,

987
00:45:49,650 --> 00:45:52,480
yield-to-maturity yield
curve, interest rate, risk.

988
00:45:52,480 --> 00:45:54,600
And then we focused
on corporate bonds.

989
00:45:54,600 --> 00:45:57,340
And I spent some time
giving the example

990
00:45:57,340 --> 00:46:00,670
of how repackaging
corporate bonds, and things

991
00:46:00,670 --> 00:46:03,610
like mortgages, auto loans,
and other securities,

992
00:46:03,610 --> 00:46:05,980
could actually lead
to some very, very

993
00:46:05,980 --> 00:46:11,200
attractive securities for a
variety of different clientele.

994
00:46:11,200 --> 00:46:14,800
For equity securities, we
applied exact same framework

995
00:46:14,800 --> 00:46:18,370
to try to come up with a
value of a future stream

996
00:46:18,370 --> 00:46:19,480
of dividends.

997
00:46:19,480 --> 00:46:22,930
And here, while the
mathematics was pretty similar,

998
00:46:22,930 --> 00:46:25,210
the interpretation differed
in an important way,

999
00:46:25,210 --> 00:46:28,420
because dividends are random,
whereas, in the case of bond

1000
00:46:28,420 --> 00:46:32,110
prices, the coupons
are known in advance.

1001
00:46:32,110 --> 00:46:35,730
So that's the difference between
fixed-income securities, where

1002
00:46:35,730 --> 00:46:38,560
the incomes are
fixed in advance,

1003
00:46:38,560 --> 00:46:41,590
versus equity securities,
where there's randomness.

1004
00:46:41,590 --> 00:46:43,600
What that randomness
does is to make

1005
00:46:43,600 --> 00:46:46,850
the volatility of these
pricing models much greater.

1006
00:46:46,850 --> 00:46:48,790
In other words, it's
harder to pin down

1007
00:46:48,790 --> 00:46:50,980
what the price of
an equity security

1008
00:46:50,980 --> 00:46:53,380
is, because in addition
to all of the risks

1009
00:46:53,380 --> 00:46:54,839
that a bond will face--

1010
00:46:54,839 --> 00:46:57,130
in other words, the risk of
future changes and interest

1011
00:46:57,130 --> 00:46:57,880
rates--

1012
00:46:57,880 --> 00:47:01,240
you get the risks of changes
in dividends, earnings,

1013
00:47:01,240 --> 00:47:03,290
cash flows, and so on.

1014
00:47:03,290 --> 00:47:06,160
We also talked about
valuing companies

1015
00:47:06,160 --> 00:47:09,250
using various different
formulas, and then the idea

1016
00:47:09,250 --> 00:47:12,640
behind PVGO, the present
value of growth opportunities,

1017
00:47:12,640 --> 00:47:15,850
and how that can actually lead
to some tremendous valuation

1018
00:47:15,850 --> 00:47:21,300
swings in a company that's based
upon intellectual property.

1019
00:47:21,300 --> 00:47:23,705
We then talked about a whole
other set of securities

1020
00:47:23,705 --> 00:47:25,830
that most of you probably
haven't come into contact

1021
00:47:25,830 --> 00:47:29,270
with-- futures versus forwards.

1022
00:47:29,270 --> 00:47:32,330
These are weird securities
in the sense that they're

1023
00:47:32,330 --> 00:47:37,100
worth nothing on the day
that you agree to enter

1024
00:47:37,100 --> 00:47:38,961
into one of these contracts.

1025
00:47:38,961 --> 00:47:40,460
But the reason
they're worth nothing

1026
00:47:40,460 --> 00:47:43,430
is that these are bilateral
agreements between two

1027
00:47:43,430 --> 00:47:45,770
counterparties
And so both of you

1028
00:47:45,770 --> 00:47:50,360
are willing to enter into this
in a willing exchange of cash

1029
00:47:50,360 --> 00:47:52,522
flow payments sometime
in the future.

1030
00:47:52,522 --> 00:47:54,230
The only reason you're
willing to do that

1031
00:47:54,230 --> 00:47:57,950
is because the contract
from an objective standpoint

1032
00:47:57,950 --> 00:48:00,470
doesn't have any NPV.

1033
00:48:00,470 --> 00:48:03,410
And we see that the marking
to market of futures

1034
00:48:03,410 --> 00:48:05,600
makes a very big
difference in terms

1035
00:48:05,600 --> 00:48:08,480
of the liquidity characteristics
of that contract.

1036
00:48:08,480 --> 00:48:11,540
We see that today with what's
going on in financial markets--

1037
00:48:11,540 --> 00:48:14,510
and that using these contracts
both for hedging purposes

1038
00:48:14,510 --> 00:48:17,960
and for speculation
is a very key aspect

1039
00:48:17,960 --> 00:48:21,430
of this whole industry.

1040
00:48:21,430 --> 00:48:22,710
Question?

1041
00:48:22,710 --> 00:48:23,210
Zeke?

1042
00:48:23,210 --> 00:48:25,350
Oh, okay.

1043
00:48:25,350 --> 00:48:28,800
Then the last set of
securities that we spent time

1044
00:48:28,800 --> 00:48:30,600
on in this course, is options.

1045
00:48:30,600 --> 00:48:33,420
Options are different
from anything else

1046
00:48:33,420 --> 00:48:35,250
we've looked at up
until now, because first

1047
00:48:35,250 --> 00:48:40,170
of all, their payoffs are
asymmetric; they're kinked.

1048
00:48:40,170 --> 00:48:42,420
And by putting together
a portfolio of options,

1049
00:48:42,420 --> 00:48:44,340
we can get all sorts
of weird payoffs.

1050
00:48:44,340 --> 00:48:47,820
In fact in the
various different exam

1051
00:48:47,820 --> 00:48:49,680
questions that
you might get, you

1052
00:48:49,680 --> 00:48:53,750
will be asked to try to come up
with different kinds of payoff

1053
00:48:53,750 --> 00:48:54,660
structures.

1054
00:48:54,660 --> 00:48:56,700
So you need to know a
little bit about how

1055
00:48:56,700 --> 00:48:58,440
to put these things
together and what

1056
00:48:58,440 --> 00:49:00,840
the various different
payoffs imply

1057
00:49:00,840 --> 00:49:02,700
under different circumstances.

1058
00:49:02,700 --> 00:49:06,390
We also gave you a very simple
example of an option pricing

1059
00:49:06,390 --> 00:49:10,200
strategy, a model, namely,
the binomial pricing model.

1060
00:49:10,200 --> 00:49:12,960
Very simple, but it's actually
one of the most heavily used

1061
00:49:12,960 --> 00:49:14,430
in industry.

1062
00:49:14,430 --> 00:49:18,840
And it's an extraordinarily
flexible and powerful method,

1063
00:49:18,840 --> 00:49:24,060
again, based on the principle
of arbitrage, or no free lunch.

1064
00:49:24,060 --> 00:49:28,590
We then started introducing risk
into the picture explicitly.

1065
00:49:28,590 --> 00:49:31,980
We talked about the size effect,
January effect, value line,

1066
00:49:31,980 --> 00:49:36,780
momentum, accruals, and pointed
out that all of these effects

1067
00:49:36,780 --> 00:49:40,140
can lead to certain
investment strategies.

1068
00:49:40,140 --> 00:49:42,300
Whether or not the
strategies are good or bad

1069
00:49:42,300 --> 00:49:43,640
really requires a framework.

1070
00:49:43,640 --> 00:49:45,722
We didn't have a
framework at the time.

1071
00:49:45,722 --> 00:49:47,430
But I wanted to point
out these anomalies

1072
00:49:47,430 --> 00:49:50,160
to just mention that
they are the basis

1073
00:49:50,160 --> 00:49:52,500
for a number of investment
products and ideas

1074
00:49:52,500 --> 00:49:53,610
over the years.

1075
00:49:53,610 --> 00:49:56,880
And so we really need to have
a systematic way of thinking

1076
00:49:56,880 --> 00:49:59,730
about how to evaluate not
only these strategies,

1077
00:49:59,730 --> 00:50:01,410
but the managers that tout them.

1078
00:50:01,410 --> 00:50:03,090
Are they adding value?

1079
00:50:03,090 --> 00:50:06,120
Or is this something that really
you could do for yourself?

1080
00:50:06,120 --> 00:50:10,200
So we developed this notion
of not so much picking

1081
00:50:10,200 --> 00:50:13,890
a stock, or a good
two or three stocks,

1082
00:50:13,890 --> 00:50:16,890
but putting together a
whole collection of stocks,

1083
00:50:16,890 --> 00:50:18,850
a good portfolio.

1084
00:50:18,850 --> 00:50:23,490
And we zeroed in on mean and
variance as the key concepts

1085
00:50:23,490 --> 00:50:27,000
to evaluate what is good
and what is not good.

1086
00:50:27,000 --> 00:50:33,180
And we deduced the main
result of finance theory

1087
00:50:33,180 --> 00:50:36,600
under uncertainty, which is
the capital asset pricing

1088
00:50:36,600 --> 00:50:38,850
model in two forms--

1089
00:50:38,850 --> 00:50:42,090
the capital market line
for efficient portfolios,

1090
00:50:42,090 --> 00:50:46,230
and the security market line
for any kind of security

1091
00:50:46,230 --> 00:50:49,360
or portfolio, whether
it's efficient or not.

1092
00:50:49,360 --> 00:50:52,980
And this allows us to
resolve the open question

1093
00:50:52,980 --> 00:50:55,050
that we started with,
which is, how do we

1094
00:50:55,050 --> 00:50:58,590
determine what the appropriate
risk-adjusted discount rate is?

1095
00:50:58,590 --> 00:51:01,260
I've said at the very beginning,
let the market determine it.

1096
00:51:01,260 --> 00:51:03,840
This allows us to
explicate how it

1097
00:51:03,840 --> 00:51:09,210
is that the market might
go about doing so, assuming

1098
00:51:09,210 --> 00:51:11,220
rationality.

1099
00:51:11,220 --> 00:51:14,730
If people aren't rational,
this goes out the window.

1100
00:51:14,730 --> 00:51:17,790
But assuming that they are,
this is a complete theory

1101
00:51:17,790 --> 00:51:20,910
for how you determine
risk and expected return.

1102
00:51:20,910 --> 00:51:24,190
And using risk an
expected return,

1103
00:51:24,190 --> 00:51:27,510
we now have a complete
theory for capital budgeting,

1104
00:51:27,510 --> 00:51:31,140
for how to evaluate whether or
not you ought to take a project

1105
00:51:31,140 --> 00:51:33,840
or not take a project, OK?

1106
00:51:33,840 --> 00:51:36,870
And last and
certainly not least,

1107
00:51:36,870 --> 00:51:40,080
we talked about the idea behind
market efficiency, the idea

1108
00:51:40,080 --> 00:51:43,630
that you can actually trust
market prices, market rates

1109
00:51:43,630 --> 00:51:47,340
of return, market betas, all
of the information that you

1110
00:51:47,340 --> 00:51:51,180
glean from market data and
apply them to your decisions.

1111
00:51:51,180 --> 00:51:52,960
Can you trust them?

1112
00:51:52,960 --> 00:51:55,170
And the answer is sometimes.

1113
00:51:55,170 --> 00:51:57,330
When markets are efficient,
when prices fully

1114
00:51:57,330 --> 00:51:59,580
reflect all available
information,

1115
00:51:59,580 --> 00:52:02,340
the power and the
wisdom of crowds

1116
00:52:02,340 --> 00:52:03,930
is very, very compelling.

1117
00:52:03,930 --> 00:52:07,560
But there are periods
where the crowd is not

1118
00:52:07,560 --> 00:52:11,260
a wise crowd, but an
angry mob, like right now.

1119
00:52:11,260 --> 00:52:13,710
So you want to be careful
and not talk to the market

1120
00:52:13,710 --> 00:52:16,230
about evaluating your
project when they're

1121
00:52:16,230 --> 00:52:19,020
trying to lynch somebody or some
financial institution that's

1122
00:52:19,020 --> 00:52:21,120
out there, OK?

1123
00:52:21,120 --> 00:52:24,180
And in order to reconcile
efficient markets

1124
00:52:24,180 --> 00:52:28,260
with these periods
of insanity, I

1125
00:52:28,260 --> 00:52:30,540
proposed this notion
of adaptive markets.

1126
00:52:30,540 --> 00:52:34,020
And at least it provides
a consistent framework

1127
00:52:34,020 --> 00:52:37,860
for thinking about these
periods of craziness,

1128
00:52:37,860 --> 00:52:41,670
as well as periods
of market calm.

1129
00:52:41,670 --> 00:52:42,960
So that's it.

1130
00:52:42,960 --> 00:52:45,210
That's it for 15.401.

1131
00:52:45,210 --> 00:52:47,640
Where you go from
here depends upon what

1132
00:52:47,640 --> 00:52:49,710
your career objectives are.

1133
00:52:49,710 --> 00:52:54,170
If you're interested in
pursuing investments,

1134
00:52:54,170 --> 00:52:56,970
if you want to be a trader,
a portfolio manager,

1135
00:52:56,970 --> 00:53:01,920
or get involved in pension asset
management, what you want to do

1136
00:53:01,920 --> 00:53:04,710
is to focus on the
investments direction, things

1137
00:53:04,710 --> 00:53:10,560
like 15.433 Investments, or
15.437 Options and Futures.

1138
00:53:10,560 --> 00:53:14,400
And we have a number of
practical pro seminars

1139
00:53:14,400 --> 00:53:15,900
that are taught
by practitioners,

1140
00:53:15,900 --> 00:53:18,840
like Seth Alexander, the
current Chief Investment

1141
00:53:18,840 --> 00:53:22,530
officer of the MIT Endowment,
or Phil Cooper, former partner

1142
00:53:22,530 --> 00:53:25,170
of Goldman Sachs who has his
own private equity company.

1143
00:53:25,170 --> 00:53:28,080
There are a number of
these practitioner courses,

1144
00:53:28,080 --> 00:53:30,570
as well as the
theoretical courses

1145
00:53:30,570 --> 00:53:33,450
that we offer that I would
encourage you to take.

1146
00:53:33,450 --> 00:53:35,730
If, on the other
hand, you're looking

1147
00:53:35,730 --> 00:53:40,890
for something on the
corporate financial side--

1148
00:53:40,890 --> 00:53:45,570
project finance, corporate
financial management,

1149
00:53:45,570 --> 00:53:48,540
that kind of approach
requires that you learn more

1150
00:53:48,540 --> 00:53:51,340
about capital budgeting,
mergers and acquisitions,

1151
00:53:51,340 --> 00:53:54,930
corporate finance, so
15.434 is a good course,

1152
00:53:54,930 --> 00:53:56,730
and certain accounting courses.

1153
00:53:56,730 --> 00:53:59,220
You might want to take
financial accounting.

1154
00:53:59,220 --> 00:54:00,630
Those are the
directions that you

1155
00:54:00,630 --> 00:54:03,060
may want to take if you're
interested in pursuing

1156
00:54:03,060 --> 00:54:05,160
that career path,

1157
00:54:05,160 --> 00:54:08,850
So both of them I think are
extraordinarily exciting.

1158
00:54:08,850 --> 00:54:11,040
They all rely on the
material that we've

1159
00:54:11,040 --> 00:54:12,540
covered in this course.

1160
00:54:12,540 --> 00:54:16,530
And so, you know, you
now have the background

1161
00:54:16,530 --> 00:54:20,270
to be able to handle any
and all of that material.