WEBVTT 00:00:00.090 --> 00:00:02.430 The following content is provided under a Creative 00:00:02.430 --> 00:00:03.850 Commons license. 00:00:03.850 --> 00:00:06.060 Your support will help MIT OpenCourseWare 00:00:06.060 --> 00:00:10.150 continue to offer high-quality educational resources for free. 00:00:10.150 --> 00:00:12.690 To make a donation or to view additional materials 00:00:12.690 --> 00:00:16.620 from hundreds of MIT courses, visit MIT OpenCourseWare 00:00:16.620 --> 00:00:17.860 at ocw.mit.edu. 00:00:27.170 --> 00:00:32.150 ANDREW LO: Any questions from last lecture? 00:00:32.150 --> 00:00:35.330 Where we left off last time was the adaptive markets 00:00:35.330 --> 00:00:36.860 hypothesis. 00:00:36.860 --> 00:00:41.720 The fact that markets are not always in everywhere efficient, 00:00:41.720 --> 00:00:45.620 but rather they satisfy the following six properties 00:00:45.620 --> 00:00:48.590 that I listed at the end of last lecture. 00:00:48.590 --> 00:00:51.230 Individuals act in their own self-interest, 00:00:51.230 --> 00:00:53.300 but they make mistakes. 00:00:53.300 --> 00:00:58.340 However, they learn and adapt, and competition drives 00:00:58.340 --> 00:01:01.160 that adaptation and innovation. 00:01:01.160 --> 00:01:05.720 Natural selection, essentially, is the mechanism 00:01:05.720 --> 00:01:10.620 that shapes the survival of the heuristics And in the end, 00:01:10.620 --> 00:01:13.670 the only thing that matters is survival. 00:01:13.670 --> 00:01:16.220 Now I illustrated how heuristics develop 00:01:16.220 --> 00:01:20.360 by giving you an example of the problem of getting dressed 00:01:20.360 --> 00:01:21.430 in the morning. 00:01:21.430 --> 00:01:23.540 And I pointed out that each of us 00:01:23.540 --> 00:01:26.240 have our own heuristics that have been developed 00:01:26.240 --> 00:01:29.150 over many, many years of selection 00:01:29.150 --> 00:01:31.220 of various different sorts. 00:01:31.220 --> 00:01:33.530 So when you take this all together 00:01:33.530 --> 00:01:37.130 and you put them into a framework that 00:01:37.130 --> 00:01:41.090 tries to focus on understanding market dynamics, 00:01:41.090 --> 00:01:42.740 you get a number of implications that 00:01:42.740 --> 00:01:46.740 are actually quite different from that of efficient markets. 00:01:46.740 --> 00:01:47.990 Let me tell you what they are. 00:01:47.990 --> 00:01:49.740 I'll give you some examples. 00:01:49.740 --> 00:01:53.390 One of the implications is that the risk-reward trade-off 00:01:53.390 --> 00:01:56.300 the relationship between risk and expected rate of return, 00:01:56.300 --> 00:02:00.210 like the CAPM's security market line. 00:02:00.210 --> 00:02:04.500 That's not stable over time or over circumstances, 00:02:04.500 --> 00:02:07.530 because individual preferences are not stable 00:02:07.530 --> 00:02:11.100 over time or over circumstances. 00:02:11.100 --> 00:02:13.440 I'll give you an example of that. 00:02:13.440 --> 00:02:15.840 Anybody know somebody who has lived through the Great 00:02:15.840 --> 00:02:21.200 Depression, OK, so grandparents or great-grandparents? 00:02:21.200 --> 00:02:24.080 My guess is that if you talk to them, 00:02:24.080 --> 00:02:27.317 or if you even observe their habits, 00:02:27.317 --> 00:02:29.400 they're actually quite different from your parents 00:02:29.400 --> 00:02:32.190 and yourselves in terms of how frugal 00:02:32.190 --> 00:02:35.700 they, are how careful they are with money, 00:02:35.700 --> 00:02:38.520 with resources, even something as simple as turning off 00:02:38.520 --> 00:02:40.650 the lights. 00:02:40.650 --> 00:02:46.430 A friend of mine is a customer a very wealthy family. 00:02:46.430 --> 00:02:49.500 They own a private business. 00:02:49.500 --> 00:02:51.900 And so their family's net worth today 00:02:51.900 --> 00:02:53.820 is probably in the order of $300 million, 00:02:53.820 --> 00:02:57.270 which, even in today's economy is worth a lot. 00:02:57.270 --> 00:03:00.810 Actually, it's worth more than what it used to be worth now. 00:03:00.810 --> 00:03:05.250 And so this family, the patriarch, the matriarch 00:03:05.250 --> 00:03:09.000 is their grandmother, who lived through the Great Depression. 00:03:09.000 --> 00:03:13.080 And she lives in Lower Manhattan in a relatively small, 00:03:13.080 --> 00:03:15.720 nondescript apartment, despite the fact 00:03:15.720 --> 00:03:19.260 that the family, you know, my friend's parents, 00:03:19.260 --> 00:03:24.120 live in a beautiful penthouse apartment on Park Avenue. 00:03:24.120 --> 00:03:26.070 And they keep asking the grandmother 00:03:26.070 --> 00:03:27.000 to move in with them. 00:03:27.000 --> 00:03:27.992 And she refuses. 00:03:27.992 --> 00:03:29.200 She just thinks it's a waste. 00:03:29.200 --> 00:03:30.570 It's embarrassing. 00:03:30.570 --> 00:03:35.100 And when she comes to visit them, she'll take the bus. 00:03:35.100 --> 00:03:40.320 She refuses to take taxis just from Lower Manhattan 00:03:40.320 --> 00:03:42.040 to Midtown. 00:03:42.040 --> 00:03:45.996 And so, you know, my friend, you know, pleads with her. 00:03:45.996 --> 00:03:47.620 You know, Nana, why are you doing this? 00:03:47.620 --> 00:03:50.450 You know, we have more money than we'll ever be able to use. 00:03:50.450 --> 00:03:51.700 You can afford to take a taxi. 00:03:51.700 --> 00:03:52.720 Let us send a car for you. 00:03:52.720 --> 00:03:53.540 Why do you do this? 00:03:53.540 --> 00:03:58.340 It's dangerous for you to take the subway or the bus. 00:03:58.340 --> 00:04:00.970 And she's like 95 years old. 00:04:00.970 --> 00:04:07.270 And she says to him, listen, Sonny. 00:04:07.270 --> 00:04:09.820 You don't remember the days that I do, 00:04:09.820 --> 00:04:13.900 when I had to stand in line and wait for my dinner, 00:04:13.900 --> 00:04:16.720 not knowing whether or not I was going to get me by the time 00:04:16.720 --> 00:04:19.130 I got to that end of that line. 00:04:19.130 --> 00:04:22.600 So don't you tell me that we have more money than will ever 00:04:22.600 --> 00:04:24.306 be able to spend. 00:04:24.306 --> 00:04:25.430 I'm sure you've heard that. 00:04:25.430 --> 00:04:28.013 Those of you who know people who lived through the depression, 00:04:28.013 --> 00:04:29.620 you've heard that. 00:04:29.620 --> 00:04:35.080 These individuals were indelibly altered by their experiences. 00:04:35.080 --> 00:04:38.290 They're not the same person before, as after, 00:04:38.290 --> 00:04:41.270 living through such difficult times. 00:04:41.270 --> 00:04:42.770 And you're not going to change them. 00:04:42.770 --> 00:04:44.530 So my friend has stopped trying. 00:04:44.530 --> 00:04:47.110 And so he just does what he can in 00:04:47.110 --> 00:04:51.910 order to make her life easier, but realizing that she simply 00:04:51.910 --> 00:04:54.280 can't enjoy the same kinds of things 00:04:54.280 --> 00:05:00.070 that he does, because she lived through such traumatic times. 00:05:00.070 --> 00:05:02.870 So if you understand that, if you acknowledge that there 00:05:02.870 --> 00:05:06.260 are people that are indelibly altered by tough times, 00:05:06.260 --> 00:05:11.150 then, in the same way, people can be indelibly altered 00:05:11.150 --> 00:05:14.150 by really good times as well. 00:05:14.150 --> 00:05:18.031 As I said last time, you learn nothing from your successes, 00:05:18.031 --> 00:05:18.530 right? 00:05:18.530 --> 00:05:20.450 Because you succeeded, what's there to learn? 00:05:20.450 --> 00:05:22.510 Do more of the same. 00:05:22.510 --> 00:05:25.370 But that affects the way you think as well. 00:05:25.370 --> 00:05:29.560 And so what we think of as this beautiful mathematical 00:05:29.560 --> 00:05:32.770 relationship, this risk-reward trade-off, the CAPM, 00:05:32.770 --> 00:05:37.300 the CAPM works if all of the assumptions that I specified 00:05:37.300 --> 00:05:38.820 are true. 00:05:38.820 --> 00:05:42.960 But those assumptions are predicated 00:05:42.960 --> 00:05:45.240 on people acting rationally. 00:05:45.240 --> 00:05:49.260 If people don't act rationally for whatever reason, 00:05:49.260 --> 00:05:52.410 if they're emotionally traumatized, 00:05:52.410 --> 00:05:55.830 if the balance between emotion and logical deliberation 00:05:55.830 --> 00:05:59.160 has been permanently altered, then the theory 00:05:59.160 --> 00:06:00.700 is not going to work. 00:06:00.700 --> 00:06:04.260 So you have to understand that when you're looking at markets, 00:06:04.260 --> 00:06:05.970 you're looking at the complexities 00:06:05.970 --> 00:06:08.400 of the interactions among various different people 00:06:08.400 --> 00:06:12.060 with different balances of logical deliberation 00:06:12.060 --> 00:06:14.950 and emotional response. 00:06:14.950 --> 00:06:16.950 So one of the things that says is 00:06:16.950 --> 00:06:20.730 that risk premia, the expected return 00:06:20.730 --> 00:06:25.040 on risky assets as a whole, is not a universal constant 00:06:25.040 --> 00:06:27.530 like, you know, gravity. 00:06:27.530 --> 00:06:31.650 It changes over time and over circumstances. 00:06:31.650 --> 00:06:34.410 It was going to be quite different 00:06:34.410 --> 00:06:38.370 if we had continuing prosperity over the next five years 00:06:38.370 --> 00:06:40.740 as to where we're likely to be headed now. 00:06:40.740 --> 00:06:41.790 It's just different. 00:06:41.790 --> 00:06:44.250 We have a different path that we're going to follow. 00:06:44.250 --> 00:06:49.830 And so as things change, market dynamics will change with them. 00:06:49.830 --> 00:06:50.330 Yeah, Zeke. 00:06:50.330 --> 00:06:52.539 AUDIENCE: So last time, we had talked 00:06:52.539 --> 00:06:58.177 about when you give somebody [INAUDIBLE] that [INAUDIBLE] 00:06:58.177 --> 00:06:58.677 and so on. 00:06:58.677 --> 00:07:01.140 And you said that lasts for a couple of hours. 00:07:01.140 --> 00:07:01.785 ANDREW LO: Yes. 00:07:01.785 --> 00:07:04.650 AUDIENCE: So with combined with what you're saying today, 00:07:04.650 --> 00:07:06.963 are you connecting the two and suggesting 00:07:06.963 --> 00:07:13.000 that such huge events actually change our biology permanently 00:07:13.000 --> 00:07:13.676 for years? 00:07:13.676 --> 00:07:15.634 Or do you think that there's a different reason 00:07:15.634 --> 00:07:18.030 behind that sort of learning? 00:07:18.030 --> 00:07:20.520 ANDREW LO: I'm saying that it can change not so 00:07:20.520 --> 00:07:22.620 much our biology, but rather, it can 00:07:22.620 --> 00:07:26.790 change our decision-making abilities for years 00:07:26.790 --> 00:07:30.090 to come, in the same way that you know your grandmother 00:07:30.090 --> 00:07:33.630 or great-grandmother was indelibly affected 00:07:33.630 --> 00:07:35.520 by living through the Great Depression, 00:07:35.520 --> 00:07:38.580 or through the Holocaust, or through some extraordinary 00:07:38.580 --> 00:07:41.730 emotional trauma, in the same way 00:07:41.730 --> 00:07:45.780 we will be affected by these sets of circumstances for years 00:07:45.780 --> 00:07:47.541 to come. 00:07:47.541 --> 00:07:48.180 Right? 00:07:48.180 --> 00:07:49.310 That's it. 00:07:49.310 --> 00:07:50.116 Ingrid. 00:07:50.116 --> 00:07:52.685 AUDIENCE: I was really impressed about two weeks ago 00:07:52.685 --> 00:07:57.480 that I heard the different networks, the channel 00:07:57.480 --> 00:08:01.355 lists trying to convince people not to getting them to buy 00:08:01.355 --> 00:08:03.480 Christmas presents, and people are 00:08:03.480 --> 00:08:06.300 going to complain because they could not not 00:08:06.300 --> 00:08:08.570 buy gifts to their kids. 00:08:08.570 --> 00:08:10.600 And where I come from, if you don't have money, 00:08:10.600 --> 00:08:12.016 you don't have money [INAUDIBLE].. 00:08:12.016 --> 00:08:17.505 So it was really surprising to see how that consumption 00:08:17.505 --> 00:08:20.150 mindset was so, so strong here. 00:08:20.150 --> 00:08:21.150 ANDREW LO: That's right. 00:08:21.150 --> 00:08:23.790 And you know, that's a very unusual mindset for the United 00:08:23.790 --> 00:08:27.330 States, because we are the land of consumers, right? 00:08:27.330 --> 00:08:30.270 I mean, consumption is what drives this economy, 00:08:30.270 --> 00:08:31.309 for better or for worse. 00:08:31.309 --> 00:08:33.600 You know, that is what has made this country as wealthy 00:08:33.600 --> 00:08:34.740 as it has. 00:08:34.740 --> 00:08:38.400 And so, it is a very difficult time when we actually 00:08:38.400 --> 00:08:40.409 have to all pull back. 00:08:40.409 --> 00:08:42.900 And you know there are some individuals that would argue 00:08:42.900 --> 00:08:44.459 that you shouldn't pull back. 00:08:44.459 --> 00:08:46.500 You should keep on spending, because if everybody 00:08:46.500 --> 00:08:50.250 keeps on spending, then somehow, magically, we will be, 00:08:50.250 --> 00:08:51.770 stay richer. 00:08:51.770 --> 00:08:53.270 That doesn't quite work. 00:08:53.270 --> 00:08:55.660 There's an adding up constraint somewhere. 00:08:55.660 --> 00:08:58.020 So wealth, if it's lost, you know, 00:08:58.020 --> 00:08:59.490 it's lost in a certain sense. 00:08:59.490 --> 00:09:02.310 And you can't create something out of nothing. 00:09:02.310 --> 00:09:05.220 But I think there are some issues about government's role 00:09:05.220 --> 00:09:07.942 in being able to maintain a certain degree of spending. 00:09:07.942 --> 00:09:09.900 So we're going to get to that in a few minutes. 00:09:09.900 --> 00:09:11.110 But you're absolutely right. 00:09:11.110 --> 00:09:15.030 This is a very big change from where we were just 00:09:15.030 --> 00:09:17.830 even a few months ago. 00:09:17.830 --> 00:09:20.220 Other implications of adaptive markets 00:09:20.220 --> 00:09:24.210 is that limited arbitrage, the so-called free lunches 00:09:24.210 --> 00:09:29.450 that we talked about, that can exist from time to time. 00:09:29.450 --> 00:09:32.060 There are free lunches on occasion, 00:09:32.060 --> 00:09:35.660 because you can think of the free lunches as opportunities 00:09:35.660 --> 00:09:38.060 that a certain group of individuals in the economy 00:09:38.060 --> 00:09:40.760 have identified which may not last. 00:09:40.760 --> 00:09:43.400 And so over time, those arbitrageurs end up 00:09:43.400 --> 00:09:48.580 getting eaten away by the arbitrageurs. 00:09:48.580 --> 00:09:52.090 But they still do exist from time to time. 00:09:52.090 --> 00:09:54.830 Free lunch programs may not exist, 00:09:54.830 --> 00:09:57.880 in other words consistent arbitrageurs time and again. 00:09:57.880 --> 00:10:01.440 That is much, much more difficult to come by. 00:10:01.440 --> 00:10:08.320 But as a result, strategies will wax and wane 00:10:08.320 --> 00:10:09.730 through different cycles. 00:10:09.730 --> 00:10:13.240 And the way it does so is exactly the same way 00:10:13.240 --> 00:10:18.580 that a beautiful, green pasture can come and go 00:10:18.580 --> 00:10:21.310 based upon ecological dynamics. 00:10:21.310 --> 00:10:25.870 In particular, a green pasture becomes a favorite spot 00:10:25.870 --> 00:10:28.840 for sheep to graze on. 00:10:28.840 --> 00:10:33.850 And after a while, as the sheep graze and get fat and multiply, 00:10:33.850 --> 00:10:38.410 they have more and more effect on that pasture. 00:10:38.410 --> 00:10:42.870 Pretty soon, with so many sheep grazing on that same pasture, 00:10:42.870 --> 00:10:44.720 the pasture is depleted. 00:10:44.720 --> 00:10:46.320 And after it's depleted, what happens 00:10:46.320 --> 00:10:48.070 to the sheep population? 00:10:48.070 --> 00:10:49.260 It declines. 00:10:49.260 --> 00:10:54.090 And the population declines, the pasture grows back, 00:10:54.090 --> 00:10:56.250 and the cycle begins all over again. 00:10:56.250 --> 00:10:57.870 Well, I have news for you. 00:10:57.870 --> 00:11:02.160 That pasture, you can think of as profits. 00:11:02.160 --> 00:11:04.660 And the sheep, you can think of as all of you. 00:11:04.660 --> 00:11:06.072 You're, the investors. 00:11:06.072 --> 00:11:08.280 And if it's profitable for you to invest in something 00:11:08.280 --> 00:11:11.160 you will keep doing it, and doing it, and doing it 00:11:11.160 --> 00:11:13.452 until there's no more pasture. 00:11:13.452 --> 00:11:15.660 That's what happened with mortgage-backed securities. 00:11:15.660 --> 00:11:17.070 There's no more pasture now. 00:11:17.070 --> 00:11:18.222 It's pretty much gone. 00:11:18.222 --> 00:11:19.680 It's going to be hard to make money 00:11:19.680 --> 00:11:21.240 in that market for a while. 00:11:21.240 --> 00:11:24.330 So all the sheep, they're going to go away now. 00:11:24.330 --> 00:11:27.510 And over time, it will come back. 00:11:27.510 --> 00:11:30.150 It may take a while, but it will come back. 00:11:30.150 --> 00:11:31.770 And that's where cycles come from. 00:11:31.770 --> 00:11:33.750 It's the exact same mechanism. 00:11:33.750 --> 00:11:35.940 This is not an analogy or a metaphor. 00:11:35.940 --> 00:11:38.340 I'm describing exactly the mechanism 00:11:38.340 --> 00:11:44.100 by which certain biological entities interact 00:11:44.100 --> 00:11:45.660 with their environment. 00:11:45.660 --> 00:11:47.220 And we are biological entities. 00:11:47.220 --> 00:11:48.390 We're creatures. 00:11:48.390 --> 00:11:51.160 And we interact in our environment. 00:11:51.160 --> 00:11:53.010 The only difference between us and sheep 00:11:53.010 --> 00:11:55.680 is that we consume dollars instead of grass. 00:11:55.680 --> 00:12:01.035 And so the dynamics are really very much the same. 00:12:01.035 --> 00:12:02.910 And the bottom line, I said, is that survival 00:12:02.910 --> 00:12:05.070 is all that matters. 00:12:05.070 --> 00:12:09.660 What any business cares about in general is surviving. 00:12:09.660 --> 00:12:11.820 And as you push for survival, a lot 00:12:11.820 --> 00:12:15.780 of the effects that you see in typical evolutionary systems 00:12:15.780 --> 00:12:19.050 will emerge in economies. 00:12:19.050 --> 00:12:21.930 So let me talk specifically about some very, very 00:12:21.930 --> 00:12:25.860 concrete examples of these kinds of dynamics. 00:12:25.860 --> 00:12:27.910 I'll give you just a couple. 00:12:27.910 --> 00:12:30.030 The first example comes from the hedge fund 00:12:30.030 --> 00:12:33.660 industry, and in particular, from very, very simple-- 00:12:33.660 --> 00:12:38.160 a simple observation about the efficiency of the stock market. 00:12:38.160 --> 00:12:40.170 When we talked about the random walk hypothesis 00:12:40.170 --> 00:12:42.210 a few weeks ago, we mentioned that the idea 00:12:42.210 --> 00:12:46.170 behind the random walk is that if prices fully 00:12:46.170 --> 00:12:49.136 reflect all available information, then certainly, 00:12:49.136 --> 00:12:50.760 you shouldn't be able to predict what's 00:12:50.760 --> 00:12:53.250 going to happen to prices tomorrow 00:12:53.250 --> 00:12:56.700 based upon what happened to prices last week, right? 00:12:56.700 --> 00:13:00.480 In other words, just because we had a positive return 00:13:00.480 --> 00:13:03.660 over the last five days, that positive return 00:13:03.660 --> 00:13:06.180 shouldn't give you any hint as to whether 00:13:06.180 --> 00:13:09.120 or not the next five days will be positive or negative, 00:13:09.120 --> 00:13:12.990 because all the information of the last five days 00:13:12.990 --> 00:13:15.790 has been incorporated into today's price. 00:13:15.790 --> 00:13:19.060 So at every point in time, it's a fair game. 00:13:19.060 --> 00:13:21.220 It's a Martingale. 00:13:21.220 --> 00:13:23.680 Well if you believe that, then what 00:13:23.680 --> 00:13:28.090 that says is that the first-order autocorrelation 00:13:28.090 --> 00:13:31.810 of monthly stock returns should be about zero. 00:13:31.810 --> 00:13:34.960 In other words, the correlation between last month's return 00:13:34.960 --> 00:13:37.600 and this month's return should be statistically 00:13:37.600 --> 00:13:40.030 indistinguishable from zero. 00:13:40.030 --> 00:13:42.070 Because if it weren't, if it were strictly 00:13:42.070 --> 00:13:44.860 positive or negative, then you'd have information 00:13:44.860 --> 00:13:48.340 to be able to base a trading strategy on, right? 00:13:48.340 --> 00:13:49.930 For example, if it were positive, 00:13:49.930 --> 00:13:51.681 then if last month's return were positive, 00:13:51.681 --> 00:13:53.138 you can bet the next month's return 00:13:53.138 --> 00:13:54.350 will continue to be positive. 00:13:54.350 --> 00:13:56.350 So you'll make a bigger bet on the stock market. 00:13:56.350 --> 00:13:57.970 You'll develop a trading strategy 00:13:57.970 --> 00:14:00.950 that can beat the market. 00:14:00.950 --> 00:14:05.720 Efficient markets hypothesis would say you can't do that. 00:14:05.720 --> 00:14:08.540 You can't come up with these kind of trading strategies. 00:14:08.540 --> 00:14:12.110 In other words, stock prices follow random walks. 00:14:12.110 --> 00:14:14.360 Autocorrelation should be 0. 00:14:14.360 --> 00:14:16.010 All right, well, let's take a look. 00:14:16.010 --> 00:14:20.450 This is the rolling five-year serial correlation 00:14:20.450 --> 00:14:23.900 coefficient-- first-order autocorrelation coefficient 00:14:23.900 --> 00:14:27.800 for stock returns on a monthly basis for the S&P 00:14:27.800 --> 00:14:35.780 composite index from January of 1871 to April of 2003. 00:14:35.780 --> 00:14:38.450 That's a lot of data, right? 00:14:38.450 --> 00:14:41.385 And if these are five-year rolling window correlations-- 00:14:41.385 --> 00:14:45.890 so every five years, I'm going to calculate the correlation 00:14:45.890 --> 00:14:50.240 coefficient between month T and month T minus 1, 00:14:50.240 --> 00:14:52.770 and it should be 0. 00:14:52.770 --> 00:14:55.180 But let's take a look at what happens. 00:14:55.180 --> 00:14:57.850 In the 1800s, the late 1800s, there 00:14:57.850 --> 00:15:01.330 was a fair bit of positive correlation, correlation 00:15:01.330 --> 00:15:03.870 around 40% or 50%. 00:15:03.870 --> 00:15:06.070 And then, towards the end of the century, 00:15:06.070 --> 00:15:08.250 the correlation goes down, then it goes up. 00:15:08.250 --> 00:15:11.400 Then it goes way down in the early 1900s. 00:15:11.400 --> 00:15:13.960 Then it goes up, then it goes down, then it goes up. 00:15:13.960 --> 00:15:16.920 During the 1970s here, there's a bit 00:15:16.920 --> 00:15:18.930 of a period where it goes down, then it goes up, 00:15:18.930 --> 00:15:20.555 then it goes down, then it goes way up. 00:15:20.555 --> 00:15:22.560 It shoots way up in the 1990s. 00:15:22.560 --> 00:15:25.830 And then, since the 1990s, it's been relatively low. 00:15:25.830 --> 00:15:28.590 And actually, if you extended it to the last few years, 00:15:28.590 --> 00:15:33.170 you'd see that it's still pretty low. 00:15:33.170 --> 00:15:37.030 This diagram shows that market efficiency, 00:15:37.030 --> 00:15:40.360 as measured by the first-order autocorrelation first of all, 00:15:40.360 --> 00:15:41.620 it's not zero. 00:15:41.620 --> 00:15:45.670 But more importantly, it does not decline monotonically 00:15:45.670 --> 00:15:46.280 over time. 00:15:46.280 --> 00:15:50.940 Markets are not getting more and more and more efficient. 00:15:50.940 --> 00:15:52.410 There's a cycle of efficiency. 00:15:52.410 --> 00:15:55.700 There are periods where the market is very efficient. 00:15:55.700 --> 00:15:58.220 And there are periods where it's not. 00:15:58.220 --> 00:16:02.990 And these periods are determined by the population 00:16:02.990 --> 00:16:06.560 of investors that are interacting with each other. 00:16:06.560 --> 00:16:09.650 There are periods where markets are extremely efficient, 00:16:09.650 --> 00:16:12.080 because you've got very sophisticated investors 00:16:12.080 --> 00:16:14.480 in the market. 00:16:14.480 --> 00:16:17.540 But during the 1990s, that wasn't one of them, 00:16:17.540 --> 00:16:19.970 because what was happening during the 1990s? 00:16:19.970 --> 00:16:21.140 Who was trading here? 00:16:21.140 --> 00:16:21.770 Anybody know? 00:16:24.970 --> 00:16:26.890 Who? 00:16:26.890 --> 00:16:27.640 Tech. 00:16:27.640 --> 00:16:29.400 But who were the traders? 00:16:29.400 --> 00:16:30.400 AUDIENCE: Everybody was. 00:16:30.400 --> 00:16:31.191 ANDREW LO: Exactly. 00:16:31.191 --> 00:16:33.280 Retail investors, everybody. 00:16:33.280 --> 00:16:36.190 You know, the librarian, the pharmacist, mom and pop, 00:16:36.190 --> 00:16:39.790 grandma, they were all trading on E-trade on all 00:16:39.790 --> 00:16:43.030 of these various different trading sites. 00:16:43.030 --> 00:16:46.895 And as a result, the market became relatively inefficient. 00:16:46.895 --> 00:16:47.770 And you can see this. 00:16:47.770 --> 00:16:49.870 You can see this as clear as day. 00:16:49.870 --> 00:16:52.630 By the way, right around here was 00:16:52.630 --> 00:16:56.530 where some of the equity market neutral hedge funds, like DE 00:16:56.530 --> 00:17:01.020 Shaw decided to go into business and made a lot of money 00:17:01.020 --> 00:17:02.950 in this period. 00:17:02.950 --> 00:17:05.740 It's gotten a lot harder now, no doubt. 00:17:05.740 --> 00:17:09.790 But my guess is that over the next few years, 00:17:09.790 --> 00:17:13.960 you may see markets becoming more inefficient. 00:17:13.960 --> 00:17:15.369 Why is that? 00:17:15.369 --> 00:17:18.339 Why might that be over the next couple of years? 00:17:18.339 --> 00:17:19.511 Any guesses? 00:17:19.511 --> 00:17:20.260 Yeah, [INAUDIBLE]? 00:17:20.260 --> 00:17:21.849 AUDIENCE: Because people are pulling out of the market? 00:17:21.849 --> 00:17:22.640 ANDREW LO: Exactly. 00:17:22.640 --> 00:17:25.420 People, particularly sophisticated investors, 00:17:25.420 --> 00:17:27.670 like hedge funds, are pulling out of the market 00:17:27.670 --> 00:17:29.050 because they're getting blown out of the water. 00:17:29.050 --> 00:17:30.530 They're losing a lot of money. 00:17:30.530 --> 00:17:32.488 They don't have enough to run their businesses. 00:17:32.488 --> 00:17:33.490 They're pulling out. 00:17:33.490 --> 00:17:39.190 And so whatever's left may not be as efficient as it once was. 00:17:39.190 --> 00:17:41.260 That's adaptive markets. 00:17:41.260 --> 00:17:42.920 That's all. 00:17:42.920 --> 00:17:45.470 Economic systems are not like physical systems. 00:17:45.470 --> 00:17:50.090 We're not approaching any kind of steady state limit. 00:17:50.090 --> 00:17:51.777 We're interacting with each other. 00:17:51.777 --> 00:17:53.360 And during certain time periods, we're 00:17:53.360 --> 00:17:55.400 going to be very efficient. 00:17:55.400 --> 00:17:57.050 And then, by the way, finance there 00:17:57.050 --> 00:17:59.080 is going to work quite well. 00:17:59.080 --> 00:18:01.360 But then there are going to be periods that are crazy. 00:18:01.360 --> 00:18:04.810 And during those crazy periods, market prices 00:18:04.810 --> 00:18:07.690 may not fully reflect all available information, 00:18:07.690 --> 00:18:13.300 in which case, markets will not be as reliable as finance 00:18:13.300 --> 00:18:14.950 theory makes them out to be. 00:18:14.950 --> 00:18:18.490 So when you apply your 401 techniques, 00:18:18.490 --> 00:18:20.470 you've got to start by asking the question, 00:18:20.470 --> 00:18:24.550 do those assumptions that we made, do they hold? 00:18:24.550 --> 00:18:26.800 Is this a reasonable period of time 00:18:26.800 --> 00:18:31.164 for which finance theory will dictate what prices should be? 00:18:31.164 --> 00:18:32.108 [INAUDIBLE] 00:18:32.108 --> 00:18:34.940 AUDIENCE: If expected return of the stock markets 00:18:34.940 --> 00:18:40.330 let's say 10%, then the other correlation shouldn't be zero. 00:18:40.330 --> 00:18:42.254 It should be around-- 00:18:42.254 --> 00:18:45.705 there's supposed to be some correlation when the market is 00:18:45.705 --> 00:18:47.980 efficient is when the next-- 00:18:47.980 --> 00:18:50.140 ANDREW LO: No, because remember, the correlation 00:18:50.140 --> 00:18:55.080 is the covariance divided by the variance in excess of the mean. 00:18:55.080 --> 00:18:57.360 These are deviations from mean, right? 00:18:57.360 --> 00:19:01.020 So it doesn't matter if it's 10%, or 20%, or 5%. 00:19:01.020 --> 00:19:02.910 If there's a trend, the mean basically 00:19:02.910 --> 00:19:05.220 subtracts that trend off. 00:19:05.220 --> 00:19:06.705 Yes. 00:19:06.705 --> 00:19:10.486 AUDIENCE: There are a few dips like, [INAUDIBLE] 00:19:10.486 --> 00:19:12.385 like [INAUDIBLE] does a dip. 00:19:12.385 --> 00:19:16.075 Like do you have an explanation about like why that happened? 00:19:16.075 --> 00:19:18.430 ANDREW LO: Well, the explanation, 00:19:18.430 --> 00:19:22.360 at least during the recent periods, I have one for you. 00:19:22.360 --> 00:19:24.140 I don't know about going back here. 00:19:24.140 --> 00:19:24.970 I can conjecture. 00:19:24.970 --> 00:19:26.428 But there are a lot of other things 00:19:26.428 --> 00:19:30.010 going on here that I can't say that I've really researched. 00:19:30.010 --> 00:19:32.420 But over here, I can tell you what happened, 00:19:32.420 --> 00:19:34.540 which is that the internet bubble burst. 00:19:34.540 --> 00:19:38.140 And then retail investors, they left the market. 00:19:38.140 --> 00:19:41.650 And who was left but sophisticated, institutional 00:19:41.650 --> 00:19:42.880 traders. 00:19:42.880 --> 00:19:45.970 And they took advantage of whatever correlation 00:19:45.970 --> 00:19:46.660 there might be. 00:19:46.660 --> 00:19:49.720 And that basically bit away any other profits 00:19:49.720 --> 00:19:51.280 that might have remained. 00:19:51.280 --> 00:19:55.690 So over the last, I don't know, maybe five to eight years, 00:19:55.690 --> 00:19:59.620 long/short equity market neutral and long/short equity 00:19:59.620 --> 00:20:01.540 strategies, that are the basis for taking 00:20:01.540 --> 00:20:03.460 advantage of these kind of correlations, 00:20:03.460 --> 00:20:04.880 have grown dramatically. 00:20:04.880 --> 00:20:08.020 And the profits have declined significantly. 00:20:08.020 --> 00:20:10.710 Markets have gotten more efficient. 00:20:10.710 --> 00:20:14.160 And you know, I would argue that during certain periods of time, 00:20:14.160 --> 00:20:17.700 for example, during the 1950s, during this period, 00:20:17.700 --> 00:20:20.670 there were situations where markets got more efficient 00:20:20.670 --> 00:20:24.090 because certain institutional investors came in, 00:20:24.090 --> 00:20:26.310 and retail investors left. 00:20:26.310 --> 00:20:32.172 So by looking at the population dynamics of the market ecology, 00:20:32.172 --> 00:20:34.130 you see, I mean, that language that I just used 00:20:34.130 --> 00:20:37.010 is language that evolutionary biologists would use. 00:20:37.010 --> 00:20:40.930 It's not something that economists would ever say. 00:20:40.930 --> 00:20:43.390 How many of you actually heard of an economist or the words 00:20:43.390 --> 00:20:45.070 that I just uttered? 00:20:45.070 --> 00:20:46.060 I don't think you have. 00:20:46.060 --> 00:20:48.250 You'll never hear it in microeconomics, 00:20:48.250 --> 00:20:52.450 because microeconomic they treat all consumers as the same. 00:20:52.450 --> 00:20:55.570 Maximize expected utility subject to a budget constraint. 00:20:55.570 --> 00:20:57.440 Or they treat all producers as the same. 00:20:57.440 --> 00:21:00.090 You can maximize profits subject to a production function 00:21:00.090 --> 00:21:03.420 or resource constraint. 00:21:03.420 --> 00:21:05.760 What economists don't recognize is 00:21:05.760 --> 00:21:07.320 that there are different populations 00:21:07.320 --> 00:21:09.840 of consumers and producers. 00:21:09.840 --> 00:21:13.780 And these populations arise in different ways. 00:21:13.780 --> 00:21:15.000 They're different species. 00:21:15.000 --> 00:21:18.370 And different species have different characteristics. 00:21:18.370 --> 00:21:20.730 And so by studying the different species, 00:21:20.730 --> 00:21:22.860 you will come up with different insights. 00:21:22.860 --> 00:21:25.830 But the reason that we don't have very many insights yet 00:21:25.830 --> 00:21:28.290 is because we don't even speak in these terms. 00:21:28.290 --> 00:21:31.570 And therefore, we don't measure the data in this way. 00:21:31.570 --> 00:21:34.390 For example, if I wanted to today, 00:21:34.390 --> 00:21:39.330 the number of retail investors versus institutional investors 00:21:39.330 --> 00:21:41.490 versus broker dealers versus hedge funds-- 00:21:41.490 --> 00:21:46.160 if I want to know the biomass of the different species, 00:21:46.160 --> 00:21:48.140 I wouldn't know where to look. 00:21:48.140 --> 00:21:50.680 There's no database that has this information, because we're 00:21:50.680 --> 00:21:51.550 not collecting it. 00:21:51.550 --> 00:21:53.740 We don't even collect the information 00:21:53.740 --> 00:21:56.470 in the way that would be the most amenable for analysis 00:21:56.470 --> 00:21:58.370 because this is such a new framework. 00:21:58.370 --> 00:22:00.730 So you've got to have the framework first to figure out 00:22:00.730 --> 00:22:02.938 what questions you want to ask and what data you want 00:22:02.938 --> 00:22:06.650 to collect. , And ultimately after you do that, over time, 00:22:06.650 --> 00:22:09.250 you'll be able to see these kind of patterns emerging. 00:22:09.250 --> 00:22:10.805 Yeah, question. 00:22:10.805 --> 00:22:12.745 AUDIENCE: [INAUDIBLE] contradicts 00:22:12.745 --> 00:22:18.014 the view of market and the [INAUDIBLE] 00:22:18.014 --> 00:22:20.424 of market and permits that say [INAUDIBLE] 00:22:20.424 --> 00:22:23.320 market the more [INAUDIBLE] the more [INAUDIBLE] 00:22:23.320 --> 00:22:24.820 ANDREW LO: Absolutely. 00:22:24.820 --> 00:22:27.100 Absolutely, it does contradict that. 00:22:27.100 --> 00:22:31.480 Yeah, this is why I leave this material to the last lecture, 00:22:31.480 --> 00:22:35.410 because, you know, I feel that it's inappropriate for me 00:22:35.410 --> 00:22:38.530 to spend an entire course in Introductory finance 00:22:38.530 --> 00:22:41.500 teaching you what my pet theories are as opposed 00:22:41.500 --> 00:22:42.460 to the mainstream. 00:22:42.460 --> 00:22:44.440 You need to know the basics of what's out there 00:22:44.440 --> 00:22:46.300 and how people use the tools. 00:22:46.300 --> 00:22:48.230 So that's what we did for 90% of the course. 00:22:48.230 --> 00:22:50.710 But I also would feel it inappropriate 00:22:50.710 --> 00:22:52.662 for me to perpetuate certain myths 00:22:52.662 --> 00:22:55.120 and let you leave this class without at least understanding 00:22:55.120 --> 00:22:57.250 that there's a debate going on, and that there's 00:22:57.250 --> 00:23:01.594 some uncertainty about exactly what theories apply when. 00:23:01.594 --> 00:23:02.260 So you're right. 00:23:02.260 --> 00:23:04.940 This does contradict the conventional wisdom. 00:23:04.940 --> 00:23:05.440 Yeah. 00:23:05.440 --> 00:23:08.158 AUDIENCE: All right, [INAUDIBLE] correctly, 00:23:08.158 --> 00:23:13.215 the points of [INAUDIBLE] rational investors. 00:23:13.215 --> 00:23:14.952 So right now, [INAUDIBLE] market. 00:23:14.952 --> 00:23:15.924 What's wrong with that? 00:23:15.924 --> 00:23:18.840 I mean, after all, we're on a path to an ineffecient market 00:23:18.840 --> 00:23:20.310 again, right? 00:23:20.310 --> 00:23:22.810 ANDREW LO: There's nothing wrong with any of this. 00:23:22.810 --> 00:23:25.570 You know, you have to keep in mind that I'm not making 00:23:25.570 --> 00:23:27.190 any value judgments whatsoever. 00:23:27.190 --> 00:23:29.901 What I'm trying to explain to you is a way of thinking, 00:23:29.901 --> 00:23:30.400 right? 00:23:30.400 --> 00:23:33.130 So I'm trying to give you a way to reconcile 00:23:33.130 --> 00:23:35.230 the various different kinds of market theories 00:23:35.230 --> 00:23:39.190 that have been proposed, the behavioral versus the rational. 00:23:39.190 --> 00:23:41.620 And what I'm arguing is that neither of these theories 00:23:41.620 --> 00:23:43.390 are complete. 00:23:43.390 --> 00:23:46.330 They each focus on one aspect of the market 00:23:46.330 --> 00:23:48.820 during one period of time. 00:23:48.820 --> 00:23:51.340 And what you need to do in order to put it 00:23:51.340 --> 00:23:55.660 all together is to develop a super theory that 00:23:55.660 --> 00:24:00.280 allows you to understand how both of these subtheories 00:24:00.280 --> 00:24:02.300 are integrated with each other. 00:24:02.300 --> 00:24:04.287 And I think this is what it does. 00:24:04.287 --> 00:24:04.786 OK? 00:24:04.786 --> 00:24:11.904 AUDIENCE: [INAUDIBLE] had said that, [INAUDIBLE] 00:24:11.904 --> 00:24:15.225 show us pretty much has a problem, because hedge 00:24:15.225 --> 00:24:18.052 funds are pretty much pulling out as a result [INAUDIBLE] 00:24:18.052 --> 00:24:20.260 ANDREW LO: Yeah, but there's nothing wrong with that. 00:24:20.260 --> 00:24:21.426 Hedge funds are pulling out. 00:24:21.426 --> 00:24:23.260 And markets will become less efficient 00:24:23.260 --> 00:24:25.756 over the next couple of years. 00:24:25.756 --> 00:24:28.550 AUDIENCE: I think it'll be more efficient, because people that 00:24:28.550 --> 00:24:31.671 have [INAUDIBLE] market, right? 00:24:31.671 --> 00:24:32.170 So-- 00:24:32.170 --> 00:24:33.753 ANDREW LO: That depends on who's left. 00:24:33.753 --> 00:24:35.950 That depends on who's left in the market. 00:24:35.950 --> 00:24:39.070 If it's institutional investors and other sophisticated 00:24:39.070 --> 00:24:40.810 investors, you may be right. 00:24:40.810 --> 00:24:42.580 But I would argue that there are going 00:24:42.580 --> 00:24:45.070 to be regular investors, like you and me, that are going 00:24:45.070 --> 00:24:46.150 to be left in the marketplace. 00:24:46.150 --> 00:24:47.941 And we're going to be running for the hills 00:24:47.941 --> 00:24:51.220 or running for the big returns. 00:24:51.220 --> 00:24:53.440 And that's going to be what drives the market 00:24:53.440 --> 00:24:55.450 for the next year or two. 00:24:55.450 --> 00:24:56.150 OK? 00:24:56.150 --> 00:24:58.400 That's going to be different than the other periods 00:24:58.400 --> 00:25:00.380 where you see inefficiencies occur, 00:25:00.380 --> 00:25:02.480 because the smart money stayed in, 00:25:02.480 --> 00:25:03.882 and the dumb money pulled out. 00:25:03.882 --> 00:25:05.090 I shouldn't say "dumb money". 00:25:05.090 --> 00:25:07.200 That's kind of value judgment. 00:25:07.200 --> 00:25:10.250 The naive money, the inexperienced money, 00:25:10.250 --> 00:25:12.440 the retail investors-- 00:25:12.440 --> 00:25:16.110 they're the ones that pulled out, you know, here. 00:25:16.110 --> 00:25:19.220 And so here, you had tremendous amounts 00:25:19.220 --> 00:25:21.200 of retail money being applied. 00:25:21.200 --> 00:25:23.270 But retail investors, they ended up 00:25:23.270 --> 00:25:26.420 losing a fair bit of money going forward. 00:25:26.420 --> 00:25:29.120 And what was left here is the hedge fund money. 00:25:29.120 --> 00:25:31.820 What I'm arguing is going to happen over the next year, what 00:25:31.820 --> 00:25:33.770 has already happened over the last year, 00:25:33.770 --> 00:25:37.270 is that hedge funds have pulled out a lot of their money. 00:25:37.270 --> 00:25:38.490 So who's left? 00:25:38.490 --> 00:25:40.170 Ask yourself, who's left? 00:25:40.170 --> 00:25:42.030 When you think about analyzing a market, 00:25:42.030 --> 00:25:44.465 don't just look at it as a mathematical object and say, 00:25:44.465 --> 00:25:45.840 I'm going to write down the CAPM, 00:25:45.840 --> 00:25:47.549 and this is what is going to tell me. 00:25:47.549 --> 00:25:49.590 If you do that, you're thinking like a physicist, 00:25:49.590 --> 00:25:50.830 not like a biologist. 00:25:50.830 --> 00:25:53.370 A biologist would say, what are the species that 00:25:53.370 --> 00:25:55.180 are here in this ecology? 00:25:55.180 --> 00:25:57.330 And once you tell me that, I'll tell you 00:25:57.330 --> 00:26:01.260 what things are going to happen over the next year or two. 00:26:01.260 --> 00:26:06.050 So let me go to now how all of this 00:26:06.050 --> 00:26:08.874 applies to the current crisis. 00:26:08.874 --> 00:26:10.790 I'm not going to talk about the details of it. 00:26:10.790 --> 00:26:12.020 We've already spent a fair bit of time 00:26:12.020 --> 00:26:13.820 this semester talking about the crisis, 00:26:13.820 --> 00:26:16.580 talking about subprime mortgages, securitization, 00:26:16.580 --> 00:26:18.590 the role of all of the various different folks 00:26:18.590 --> 00:26:20.360 that were participating. 00:26:20.360 --> 00:26:23.540 But I want to make the following point based upon the material 00:26:23.540 --> 00:26:25.970 that we covered last time. 00:26:25.970 --> 00:26:33.050 And that is the fact that pain protects. 00:26:33.050 --> 00:26:36.830 This is a very important, but rather obvious 00:26:36.830 --> 00:26:40.970 point, that I suspect many of you may have overlooked. 00:26:40.970 --> 00:26:43.670 And let me just describe to you a very simple illustration 00:26:43.670 --> 00:26:44.770 of it. 00:26:44.770 --> 00:26:47.270 Have any of you run across people 00:26:47.270 --> 00:26:50.270 that have had like temporary nerve damage? 00:26:50.270 --> 00:26:53.840 You know, their arm goes numb for whatever reason. 00:26:53.840 --> 00:26:56.394 Anybody see what happens to that arm, 00:26:56.394 --> 00:26:58.310 you know, over the course of a couple of weeks 00:26:58.310 --> 00:27:01.400 after the nerve damage sets in? 00:27:01.400 --> 00:27:03.400 Anybody know? 00:27:03.400 --> 00:27:05.560 You have seen situations where that happens? 00:27:05.560 --> 00:27:06.060 Yeah, Mike. 00:27:06.060 --> 00:27:07.050 AUDIENCE: I was going to say, somewhere 00:27:07.050 --> 00:27:09.300 there was a little girl who couldn't feel pain at all. 00:27:09.300 --> 00:27:11.531 And she had the-- she kept clawing her eyes out. 00:27:11.531 --> 00:27:14.530 And she was completely bruised because she just 00:27:14.530 --> 00:27:15.760 bumped into everything. 00:27:15.760 --> 00:27:17.182 ANDREW LO: That's right. 00:27:17.182 --> 00:27:17.890 It's interesting. 00:27:17.890 --> 00:27:20.050 When you see these individuals, they 00:27:20.050 --> 00:27:24.940 look like they've been in a cat fight with a tiger. 00:27:24.940 --> 00:27:27.340 You know, they're scratched, bruised, you know, 00:27:27.340 --> 00:27:29.311 they've got these incredible wounds. 00:27:29.311 --> 00:27:31.060 And you ask them, you know, what happened? 00:27:31.060 --> 00:27:31.851 Did you get mugged? 00:27:31.851 --> 00:27:33.890 Did you get beaten up? 00:27:33.890 --> 00:27:35.300 And they'll say no. 00:27:35.300 --> 00:27:38.360 It's just walking around. 00:27:38.360 --> 00:27:43.600 It turns out that if you can't feel in your left arm, 00:27:43.600 --> 00:27:49.350 if it's numb, then you won't know to pull away 00:27:49.350 --> 00:27:54.460 when you scrape it on the edge of a sharp chair, 00:27:54.460 --> 00:27:58.840 or you get pricked by some kind of tool. 00:27:58.840 --> 00:28:00.160 You won't know to pull back. 00:28:00.160 --> 00:28:01.660 You might just keep pushing forward. 00:28:01.660 --> 00:28:05.020 And you know, there goes a scratch, and a cut, 00:28:05.020 --> 00:28:06.760 and a puncture. 00:28:06.760 --> 00:28:12.300 If you can't feel pain, you can't protect yourself. 00:28:12.300 --> 00:28:14.820 Pain protects. 00:28:14.820 --> 00:28:19.630 If you think about any kind of measure you have ever taken 00:28:19.630 --> 00:28:22.420 that has protected you, whether it's pulling money out 00:28:22.420 --> 00:28:25.540 of the stock market, whether it's getting out of a burning 00:28:25.540 --> 00:28:29.560 house, whether it's avoiding a certain situation because you 00:28:29.560 --> 00:28:32.740 know that it would likely turn into a very bad accident, 00:28:32.740 --> 00:28:37.440 like driving after you've had too much to drink-- 00:28:37.440 --> 00:28:42.120 if you've ever done anything that involves pulling back 00:28:42.120 --> 00:28:45.660 from taking a risk, it's because you have 00:28:45.660 --> 00:28:48.400 felt pain, either current pain. 00:28:48.400 --> 00:28:55.140 Or you have felt the memory of previous pain. 00:28:55.140 --> 00:28:57.450 Now let me ask you a question. 00:28:57.450 --> 00:29:02.860 Suppose none of you are feeling any pain. 00:29:02.860 --> 00:29:05.300 Will you actually be able to control yourself 00:29:05.300 --> 00:29:08.330 from taking on certain risks? 00:29:08.330 --> 00:29:12.970 So this gets back to the crisis that we're in right now. 00:29:12.970 --> 00:29:16.720 If in 2004 or 2005, you were at one 00:29:16.720 --> 00:29:18.760 of these financial institutions that 00:29:18.760 --> 00:29:21.210 invested in these kinds of securities 00:29:21.210 --> 00:29:23.380 or these strategies-- and not everyone did. 00:29:23.380 --> 00:29:27.520 So I don't mean to make a sweeping generalization. 00:29:27.520 --> 00:29:29.680 But a number of very large institutions 00:29:29.680 --> 00:29:31.720 seem to have overextended themselves. 00:29:34.760 --> 00:29:37.730 What I want to argue is that this is not 00:29:37.730 --> 00:29:42.710 something that is very easily preventable unless we impose 00:29:42.710 --> 00:29:49.130 certain restrictions in advance, unless we decide before we ever 00:29:49.130 --> 00:29:53.960 enter that situation that we're not going to do something, 00:29:53.960 --> 00:29:58.460 because otherwise it's going to be impossible for us to avoid 00:29:58.460 --> 00:30:03.080 doing it when it feels so good, when we are in no pain. 00:30:03.080 --> 00:30:05.150 I want to be even more specific. 00:30:05.150 --> 00:30:10.970 It turns out that financial gain, monetary reward, 00:30:10.970 --> 00:30:13.610 actually stimulates the same reward 00:30:13.610 --> 00:30:17.720 circuitry that cocaine does. 00:30:17.720 --> 00:30:18.620 I'm not kidding. 00:30:18.620 --> 00:30:20.760 This is not an analogy or a metaphor. 00:30:20.760 --> 00:30:22.430 It's a physiological fact. 00:30:22.430 --> 00:30:25.190 Neuroscientists using fMRI machines 00:30:25.190 --> 00:30:29.330 had individuals play games involving real money-- 00:30:29.330 --> 00:30:33.320 not a lot of money, but enough so that it actually registered. 00:30:33.320 --> 00:30:38.290 And it turns out that they found that when people made money 00:30:38.290 --> 00:30:45.550 in the MRI machine, that their brain released dopamine 00:30:45.550 --> 00:30:49.180 into a region of the brain called the nucleus accumbens. 00:30:49.180 --> 00:30:51.010 This is exactly the same thing that 00:30:51.010 --> 00:30:54.400 happens when you take cocaine. 00:30:54.400 --> 00:30:56.160 Some people have said that making money 00:30:56.160 --> 00:30:58.080 is better than sex. 00:30:58.080 --> 00:30:58.840 You know what? 00:30:58.840 --> 00:31:02.250 That's actually not an exaggeration. 00:31:02.250 --> 00:31:06.340 It stimulates the same kind of neural circuitry. 00:31:06.340 --> 00:31:10.930 And when you are in this kind of a mode of reaction, 00:31:10.930 --> 00:31:14.230 when your nucleus accumbens is being hyperstimulated 00:31:14.230 --> 00:31:20.010 by dopamine, it will be very hard, almost impossible for you 00:31:20.010 --> 00:31:22.590 to pull back and say, no. 00:31:22.590 --> 00:31:24.030 I don't want to. 00:31:24.030 --> 00:31:26.310 That's what an addiction is, frankly. 00:31:26.310 --> 00:31:29.220 And for extended periods of prosperity, 00:31:29.220 --> 00:31:32.580 which we have had over the last 10 years, 00:31:32.580 --> 00:31:34.530 it's become virtually impossible. 00:31:34.530 --> 00:31:35.760 I'm not condoning it. 00:31:35.760 --> 00:31:36.700 Don't get me wrong. 00:31:36.700 --> 00:31:40.240 I'm not arguing that these excesses are just fine 00:31:40.240 --> 00:31:41.430 and we excuse them. 00:31:41.430 --> 00:31:43.290 I'm actually explaining a biological fact 00:31:43.290 --> 00:31:45.540 about how all of us are hardwired. 00:31:45.540 --> 00:31:50.730 When we're making money, it's very hard for us to pull back-- 00:31:50.730 --> 00:31:56.520 so much so, that as a society, it is possible for us 00:31:56.520 --> 00:31:59.640 to overextend ourselves. 00:31:59.640 --> 00:32:05.260 And this actually is one role that regulation can play. 00:32:05.260 --> 00:32:07.260 You know, economists have argued that government 00:32:07.260 --> 00:32:10.380 should be involved because we have public goods. 00:32:10.380 --> 00:32:11.520 We have externalities. 00:32:11.520 --> 00:32:13.027 We have incomplete markets. 00:32:13.027 --> 00:32:15.360 But I think that economists have missed the most obvious 00:32:15.360 --> 00:32:19.650 motivation for regulation, which is regulation 00:32:19.650 --> 00:32:23.310 is a means by which society prevents itself 00:32:23.310 --> 00:32:26.820 from doing the things that it knows it doesn't want to do 00:32:26.820 --> 00:32:30.090 during those periods where it is incapable of stopping itself 00:32:30.090 --> 00:32:31.181 from doing it. 00:32:31.181 --> 00:32:31.680 Right? 00:32:31.680 --> 00:32:33.780 This is why some people put their potato chips 00:32:33.780 --> 00:32:35.759 on the very top shell in their kitchen. 00:32:35.759 --> 00:32:37.800 They know that they shouldn't be having too many. 00:32:37.800 --> 00:32:40.920 So they make it harder to get it so that when they get it, 00:32:40.920 --> 00:32:43.010 you know, it provides some kind of distance. 00:32:43.010 --> 00:32:44.260 And that doesn't work so well. 00:32:44.260 --> 00:32:46.510 I can attest to that. 00:32:46.510 --> 00:32:47.910 But I'll give you another example 00:32:47.910 --> 00:32:49.409 I'll give you another example that's 00:32:49.409 --> 00:32:51.420 a little bit more direct. 00:32:51.420 --> 00:32:54.000 In every state in the United States, 00:32:54.000 --> 00:33:00.640 we impose fire codes on builders, fire codes that 00:33:00.640 --> 00:33:04.240 require you to have a minimum number of exits, 00:33:04.240 --> 00:33:08.350 to have well-lit exit signs that you can see, 00:33:08.350 --> 00:33:11.080 to have visible fire alarms, to have sprinkler 00:33:11.080 --> 00:33:12.220 systems in the ceiling. 00:33:12.220 --> 00:33:13.660 All of this stuff costs money. 00:33:13.660 --> 00:33:15.990 It's actually very expensive to put it. 00:33:15.990 --> 00:33:18.480 Do you ever wonder why we have those? 00:33:18.480 --> 00:33:21.330 In other words, why not let the free market work? 00:33:21.330 --> 00:33:23.040 Let people be free to choose. 00:33:23.040 --> 00:33:24.750 Those of you that are nervous Nellies 00:33:24.750 --> 00:33:26.820 that are worried about a fire, you 00:33:26.820 --> 00:33:28.980 will simply pay more for buildings 00:33:28.980 --> 00:33:31.200 that have all these goodies. 00:33:31.200 --> 00:33:33.360 And then we can have other buildings 00:33:33.360 --> 00:33:35.730 that don't have any of these protections. 00:33:35.730 --> 00:33:38.585 And let people be free to choose. 00:33:38.585 --> 00:33:39.460 Why don't we do that? 00:33:39.460 --> 00:33:41.140 That's a perfect equilibrium from an economist 00:33:41.140 --> 00:33:41.723 point of view. 00:33:41.723 --> 00:33:42.860 Well, you know why? 00:33:42.860 --> 00:33:46.530 It's because in that free-to-choose world, 00:33:46.530 --> 00:33:49.239 none of you will choose the more expensive building. 00:33:49.239 --> 00:33:50.280 And the reason is simple. 00:33:50.280 --> 00:33:53.550 It's because when you assess the probability 00:33:53.550 --> 00:33:57.360 of a fire on any given day, you put a weight of zero 00:33:57.360 --> 00:33:58.059 to that event. 00:33:58.059 --> 00:33:59.850 I don't any of you came into this classroom 00:33:59.850 --> 00:34:01.710 today thinking hmm, if there's a fire, who 00:34:01.710 --> 00:34:05.574 am I going to have to step over to get out of that exit? 00:34:05.574 --> 00:34:06.990 Maybe you are thinking about that. 00:34:06.990 --> 00:34:10.139 That's why you guys are sitting here. 00:34:10.139 --> 00:34:12.840 But we don't think about it, because it's not 00:34:12.840 --> 00:34:15.690 part of our cognitive process to focus 00:34:15.690 --> 00:34:17.760 on every possible eventuality. 00:34:17.760 --> 00:34:22.750 We don't have an infinite computing machine on our heads. 00:34:22.750 --> 00:34:27.949 So we assign certain events zero probability. 00:34:27.949 --> 00:34:30.710 And when you do, you will pay nothing for it. 00:34:30.710 --> 00:34:32.420 So there will be nobody that will 00:34:32.420 --> 00:34:36.380 pay for sprinklers, in which case, it won't get done. 00:34:36.380 --> 00:34:39.409 And as we know, when it doesn't get done, 00:34:39.409 --> 00:34:41.210 eventually, you have a fire. 00:34:41.210 --> 00:34:45.710 And during that fire, you really wish you had those sprinklers. 00:34:45.710 --> 00:34:48.510 And it'll be too late to put them in at that time. 00:34:48.510 --> 00:34:49.610 So we regulate. 00:34:49.610 --> 00:34:52.429 We regulate because we know ourselves. 00:34:52.429 --> 00:34:55.010 And we know that during certain situations, 00:34:55.010 --> 00:34:59.430 we will not act in a way that we would like ourselves to act. 00:34:59.430 --> 00:35:01.700 So we prevent ourselves from doing that 00:35:01.700 --> 00:35:07.770 by developing these laws that we just simply have to follow. 00:35:07.770 --> 00:35:11.850 Well, that can be done as well for problems 00:35:11.850 --> 00:35:15.300 like leverage credit and so on. 00:35:15.300 --> 00:35:18.180 So the point is that risk management 00:35:18.180 --> 00:35:23.790 doesn't work unless we are able to experience pain and fear. 00:35:23.790 --> 00:35:28.350 And profits are a very potent anesthetic. 00:35:28.350 --> 00:35:29.700 They're like a drug. 00:35:29.700 --> 00:35:32.160 And the more profit you have, for a long enough period 00:35:32.160 --> 00:35:35.910 of time, you become a lot less anxious about asking questions, 00:35:35.910 --> 00:35:38.130 because you're not feeling any pain. 00:35:38.130 --> 00:35:41.100 You're not feeling pain, so you won't ask the tough questions. 00:35:41.100 --> 00:35:43.230 And you won't scale back the risks 00:35:43.230 --> 00:35:47.370 while everybody else seems to be doing just fine. 00:35:47.370 --> 00:35:52.560 So the point is that proper balance is the key. 00:35:52.560 --> 00:35:56.310 We have to have a proper balance of fear, greed, 00:35:56.310 --> 00:35:58.320 and logical analysis. 00:35:58.320 --> 00:36:00.570 And if we know that there are periods 00:36:00.570 --> 00:36:03.660 where that proper balance will be out of kilter, 00:36:03.660 --> 00:36:08.540 that's the role that regulation can play during those periods. 00:36:08.540 --> 00:36:10.120 OK? 00:36:10.120 --> 00:36:13.460 So what do we what do we think about going forward? 00:36:13.460 --> 00:36:18.420 Well, clearly the fear of the unknown 00:36:18.420 --> 00:36:20.820 magnifies the problems that were in. 00:36:20.820 --> 00:36:23.910 Flight to liquidity is likely to persist. 00:36:23.910 --> 00:36:26.190 And we really are going to have to think 00:36:26.190 --> 00:36:29.760 more carefully about developing better analytics. 00:36:29.760 --> 00:36:32.580 And ultimately, what we're going to see over 00:36:32.580 --> 00:36:36.300 the next couple of years is a tremendous period 00:36:36.300 --> 00:36:37.920 of innovation-- 00:36:37.920 --> 00:36:40.680 some of it good, some of it bad. 00:36:40.680 --> 00:36:44.280 But we're going to use the current situation 00:36:44.280 --> 00:36:49.230 to really improve and expand the current infrastructure 00:36:49.230 --> 00:36:51.010 for the coming decades. 00:36:51.010 --> 00:36:55.500 So as one of the Obama transition managers mentioned, 00:36:55.500 --> 00:36:57.870 a crisis is a terrible thing to waste. 00:36:57.870 --> 00:37:01.950 The next year or two is a golden opportunity for us 00:37:01.950 --> 00:37:04.770 to take advantage of the crisis by motivating 00:37:04.770 --> 00:37:08.790 ourselves to change the regulatory infrastructure. 00:37:08.790 --> 00:37:09.360 Right? 00:37:09.360 --> 00:37:11.820 If things are going well, then there's 00:37:11.820 --> 00:37:14.100 no point in trying to change anything, right? 00:37:14.100 --> 00:37:15.240 Don't mess with success. 00:37:15.240 --> 00:37:17.204 You've heard that before. 00:37:17.204 --> 00:37:18.620 The point is that right now, we're 00:37:18.620 --> 00:37:21.170 in a situation where we can actually change something. 00:37:21.170 --> 00:37:23.150 And so the adaptive markets would tell us 00:37:23.150 --> 00:37:27.020 that this is our way of creating that infrastructure 00:37:27.020 --> 00:37:30.910 to build for the coming growth. 00:37:30.910 --> 00:37:36.660 So in conclusion, I would argue that finance and economics are 00:37:36.660 --> 00:37:39.000 a lot more like evolutionary biology 00:37:39.000 --> 00:37:41.277 than they are like physics. 00:37:41.277 --> 00:37:43.860 We really have to take a look at the evolutionary perspective. 00:37:43.860 --> 00:37:47.880 And the bottom line is whether or not 00:37:47.880 --> 00:37:50.100 you are going to survive. 00:37:50.100 --> 00:37:51.920 That's what we all care about. 00:37:51.920 --> 00:37:54.750 That's what we ultimately strive to do. 00:37:54.750 --> 00:37:57.870 And if you understand this about markets, 00:37:57.870 --> 00:38:00.570 you'll have a much better chance of surviving. 00:38:00.570 --> 00:38:03.090 So from the perspective of 401, the material 00:38:03.090 --> 00:38:05.160 we've learned in this course, we've 00:38:05.160 --> 00:38:10.240 gone over the rational approach to analyzing value 00:38:10.240 --> 00:38:13.140 in various kinds of market interactions. 00:38:13.140 --> 00:38:16.080 And just be aware that for the most part, 00:38:16.080 --> 00:38:18.030 that may work reasonably well. 00:38:18.030 --> 00:38:22.350 But for extreme circumstances, periods of extreme wealth, 00:38:22.350 --> 00:38:26.750 as well as periods of extreme market distress, 00:38:26.750 --> 00:38:31.790 prices may not be in-line with what our analytical framework 00:38:31.790 --> 00:38:32.360 suggests. 00:38:32.360 --> 00:38:34.970 And at that point, you need to reassess and try 00:38:34.970 --> 00:38:36.990 to come up with alternatives. 00:38:36.990 --> 00:38:40.280 What those are, we currently don't know. 00:38:40.280 --> 00:38:42.620 We don't have a good theory for what 00:38:42.620 --> 00:38:45.920 happens when the traditional analytics break down, 00:38:45.920 --> 00:38:47.960 because up until recently, nobody 00:38:47.960 --> 00:38:49.490 would be even willing to consider 00:38:49.490 --> 00:38:52.141 that the traditional analytics would ever break down. 00:38:52.141 --> 00:38:52.640 OK? 00:38:52.640 --> 00:38:55.560 So this whole area is relatively new. 00:38:55.560 --> 00:38:58.350 And as I mentioned, at the beginning of this lecture, 00:38:58.350 --> 00:39:00.341 if you do a search for adaptive markets, 00:39:00.341 --> 00:39:02.090 you're going to only find my name attached 00:39:02.090 --> 00:39:03.050 to that at this point. 00:39:03.050 --> 00:39:06.710 It's not really a theory that's come into even common parlance, 00:39:06.710 --> 00:39:08.960 never mind general acceptance. 00:39:08.960 --> 00:39:10.540 It's a conjecture at this point. 00:39:10.540 --> 00:39:14.850 It's an alternative to the current received wisdom. 00:39:14.850 --> 00:39:18.200 But the hope is that over time, as we understand more and more 00:39:18.200 --> 00:39:21.080 about these interactions, we'll be able to develop alternative. 00:39:21.080 --> 00:39:23.900 So then, I'm hoping that a few years from now, 00:39:23.900 --> 00:39:25.610 I will be able to tell all of you, 00:39:25.610 --> 00:39:28.910 this is a theory for markets when they are normal. 00:39:28.910 --> 00:39:32.150 And this is a theory for markets under certain kinds 00:39:32.150 --> 00:39:33.500 of distress. 00:39:33.500 --> 00:39:37.250 And at that point, we will have a complete theory of markets 00:39:37.250 --> 00:39:38.480 under all circumstances. 00:39:38.480 --> 00:39:40.388 But we're still a few years away from that. 00:39:40.388 --> 00:39:41.264 [INAUDIBLE] 00:39:41.264 --> 00:39:44.445 AUDIENCE: There are a number of economists the value 00:39:44.445 --> 00:39:47.330 that the financial sector in the US 00:39:47.330 --> 00:39:50.920 was already among the most regulated sectors. 00:39:50.920 --> 00:39:55.295 But partially these regulations caused [INAUDIBLE] Fannie Mae 00:39:55.295 --> 00:39:56.740 and Freddie Mac. 00:39:56.740 --> 00:40:00.738 And so actually, I would argue for the opposite. 00:40:00.738 --> 00:40:02.530 And do you think that the regulation 00:40:02.530 --> 00:40:07.845 should be fixed because it's wrong, or you should add more? 00:40:07.845 --> 00:40:10.820 ANDREW LO: Well, I don't think we should add more. 00:40:10.820 --> 00:40:13.710 I would argue that we don't need more regulation. 00:40:13.710 --> 00:40:16.500 We need better regulation, smarter, 00:40:16.500 --> 00:40:18.770 more adaptive regulation. 00:40:18.770 --> 00:40:22.500 So to your point, the banking sector, 00:40:22.500 --> 00:40:28.120 which is where the majority of these problems sit today, 00:40:28.120 --> 00:40:31.000 the banking sector is the most regulated sector 00:40:31.000 --> 00:40:34.390 of all in all of the financial world. 00:40:34.390 --> 00:40:39.730 And the next most regulated sector is the insurance sector. 00:40:39.730 --> 00:40:41.870 And you have problems there, too. 00:40:41.870 --> 00:40:44.680 So on the one hand, you could argue that gee, 00:40:44.680 --> 00:40:47.170 it's all this regulation that's created it. 00:40:47.170 --> 00:40:49.000 I don't believe that either. 00:40:49.000 --> 00:40:51.760 And the reason is that a lot of these problems 00:40:51.760 --> 00:40:57.790 started in 1999 and after when we actually 00:40:57.790 --> 00:41:00.340 dismantled some of the regulation, 00:41:00.340 --> 00:41:02.470 in particular the Glass-Steagall Act. 00:41:02.470 --> 00:41:04.240 We dismantled that in 1999. 00:41:04.240 --> 00:41:06.910 And by the way, that wasn't done by the Republicans. 00:41:06.910 --> 00:41:08.110 Bill Clinton signed that. 00:41:08.110 --> 00:41:11.670 So there's blame to share across both political parties. 00:41:11.670 --> 00:41:15.510 This is not a political problem, per say. 00:41:15.510 --> 00:41:17.310 So we reduced regulation. 00:41:17.310 --> 00:41:19.320 We allowed banks to be more like hedge funds. 00:41:19.320 --> 00:41:22.200 We allowed hedge funds to be more like banks. 00:41:22.200 --> 00:41:26.640 And we got ourselves into the problem that we face today. 00:41:26.640 --> 00:41:28.200 So it's not more regulation. 00:41:28.200 --> 00:41:31.260 We have to be smarter about what we're regulating. 00:41:31.260 --> 00:41:33.630 And that's what I'm hoping that we will 00:41:33.630 --> 00:41:37.170 do over the next few years. 00:41:37.170 --> 00:41:40.220 OK, well, that's it. 00:41:40.220 --> 00:41:44.000 That's it for Introductory Finance. 00:41:44.000 --> 00:41:48.600 What I want to do now in just the last 15 or 20 minutes, 00:41:48.600 --> 00:41:50.944 I'm going to give you a near-death experience, 00:41:50.944 --> 00:41:52.610 because you get to see the entire course 00:41:52.610 --> 00:41:54.620 flash before your very eyes. 00:41:54.620 --> 00:41:58.340 I want to go over what we've done to-date 00:41:58.340 --> 00:41:59.732 and try to make sense of it all. 00:41:59.732 --> 00:42:01.190 And then I'll tell you a little bit 00:42:01.190 --> 00:42:07.030 about what you might be in store for with classes in the future. 00:42:07.030 --> 00:42:11.570 So let's start at the very beginning. 00:42:11.570 --> 00:42:15.470 I started with this motivation-- mathematics plus money 00:42:15.470 --> 00:42:16.400 is equal to finance. 00:42:16.400 --> 00:42:19.160 And I hope that I've delivered on that. 00:42:19.160 --> 00:42:22.310 In other words, we've got very different approaches 00:42:22.310 --> 00:42:23.510 to investments. 00:42:23.510 --> 00:42:25.940 At the one in the spectrum, James Simons, 00:42:25.940 --> 00:42:29.060 at the other, Warren Buffett, and, of course, 00:42:29.060 --> 00:42:31.430 Jack Welch in-between. 00:42:31.430 --> 00:42:35.090 And each of these individuals brings unique skills 00:42:35.090 --> 00:42:37.550 and insights into the investment process. 00:42:37.550 --> 00:42:39.810 And what we wanted to do in this course, 00:42:39.810 --> 00:42:43.280 was to try to distill some of the basic principles 00:42:43.280 --> 00:42:46.820 and the language of finance that all three of these individuals 00:42:46.820 --> 00:42:48.740 would agree are sort of the building 00:42:48.740 --> 00:42:52.070 blocks of understanding market dynamics. 00:42:52.070 --> 00:42:54.650 And as we started at the beginning 00:42:54.650 --> 00:42:56.840 with this flow model of the economy, 00:42:56.840 --> 00:42:59.240 we said that we were going to study four components-- 00:42:59.240 --> 00:43:02.420 households, capital markets, financial intermediaries, 00:43:02.420 --> 00:43:03.740 and non-financial corporations. 00:43:03.740 --> 00:43:07.560 That's the financial system as we know it. 00:43:07.560 --> 00:43:11.570 And we began with those six principles of modern finance. 00:43:11.570 --> 00:43:13.922 Now I think you have a deeper appreciation for it. 00:43:13.922 --> 00:43:15.380 As I said, we were only going to be 00:43:15.380 --> 00:43:18.260 able to focus on the first few. 00:43:18.260 --> 00:43:20.450 And the latter principles were going 00:43:20.450 --> 00:43:22.700 to be underlying much of the theories 00:43:22.700 --> 00:43:24.957 that you would study beyond this course. 00:43:24.957 --> 00:43:26.540 There's no such thing as a free lunch. 00:43:26.540 --> 00:43:30.450 That's a very basic principle that we used time and again 00:43:30.450 --> 00:43:33.650 in coming up with various different pricing implications. 00:43:33.650 --> 00:43:37.010 And P2 is the behavioral assumption 00:43:37.010 --> 00:43:40.100 that I argued we need for much of the theories 00:43:40.100 --> 00:43:41.280 that we developed. 00:43:41.280 --> 00:43:43.370 But what I just told you in the last lecture 00:43:43.370 --> 00:43:45.830 is that there are occasions where 00:43:45.830 --> 00:43:48.800 those behavioral assumptions, ultimately, 00:43:48.800 --> 00:43:51.470 are suspended or replaced with this kind 00:43:51.470 --> 00:43:54.110 of overwhelming emotional component. 00:43:54.110 --> 00:43:55.790 We prefer more money to less, prefer 00:43:55.790 --> 00:43:59.260 money now to money later, and we prefer to avoid risk. 00:43:59.260 --> 00:44:02.570 P3-- all agents act to further their own self-interest. 00:44:02.570 --> 00:44:03.970 That's pretty straightforward. 00:44:03.970 --> 00:44:06.080 P4-- financial market prices shift 00:44:06.080 --> 00:44:08.510 to equate supply and demand. 00:44:08.510 --> 00:44:11.792 And then P5-- financial markets highly adaptive-competitive, 00:44:11.792 --> 00:44:13.250 and that risk-sharing and frictions 00:44:13.250 --> 00:44:15.620 are central to financial innovation. 00:44:15.620 --> 00:44:17.540 I hope that throughout the entire course 00:44:17.540 --> 00:44:20.930 you've got an appreciation for all six of these principles. 00:44:20.930 --> 00:44:25.160 It's remarkable how such relatively simple ideas 00:44:25.160 --> 00:44:28.130 can have such dramatic implications as we've developed 00:44:28.130 --> 00:44:30.690 over the last 13 weeks. 00:44:30.690 --> 00:44:33.280 OK so there are four sections that we focused 00:44:33.280 --> 00:44:36.070 on-- the introduction, evaluation, risk, 00:44:36.070 --> 00:44:37.420 and corporate finance. 00:44:37.420 --> 00:44:40.780 And then the final lecture of "Try to put it all together." 00:44:40.780 --> 00:44:44.170 For present value, the focus really 00:44:44.170 --> 00:44:47.530 was defining what an asset is-- a package, a sequence of cash 00:44:47.530 --> 00:44:50.620 flows, and the time value of money, 00:44:50.620 --> 00:44:53.530 looking at present value versus future value, 00:44:53.530 --> 00:44:57.830 and focusing on exchange rates between today, tomorrow, 00:44:57.830 --> 00:44:58.600 and other dates. 00:44:58.600 --> 00:45:00.610 That was sort of the key insight. 00:45:00.610 --> 00:45:04.900 And once you understand how to visualize the cash flows 00:45:04.900 --> 00:45:09.670 and move money through time, you understand a very significant 00:45:09.670 --> 00:45:12.421 portion of financial analysis. 00:45:12.421 --> 00:45:14.170 And then we talked about some special cash 00:45:14.170 --> 00:45:16.000 flows-- perpetuities and annuities, 00:45:16.000 --> 00:45:18.190 which we use for virtually everything in terms 00:45:18.190 --> 00:45:18.910 of valuation. 00:45:18.910 --> 00:45:20.830 Very important ideas. 00:45:20.830 --> 00:45:24.310 And then we talked a bit about compounding and inflation. 00:45:24.310 --> 00:45:26.200 Fixed-income securities-- Well, we 00:45:26.200 --> 00:45:29.080 talked about applying the very basic mathematics 00:45:29.080 --> 00:45:33.520 of present value to these pure discount bonds and coupon 00:45:33.520 --> 00:45:34.625 bonds. 00:45:34.625 --> 00:45:37.000 The relationship between coupon bonds and discount bonds, 00:45:37.000 --> 00:45:40.150 of course, is through arbitrage. 00:45:40.150 --> 00:45:42.940 And we also found that current bond prices 00:45:42.940 --> 00:45:45.190 contain enormous amounts of information 00:45:45.190 --> 00:45:47.900 about what's going to happen in the future. 00:45:47.900 --> 00:45:49.650 We talked about spot rates, forward rates, 00:45:49.650 --> 00:45:52.480 yield-to-maturity yield curve, interest rate, risk. 00:45:52.480 --> 00:45:54.600 And then we focused on corporate bonds. 00:45:54.600 --> 00:45:57.340 And I spent some time giving the example 00:45:57.340 --> 00:46:00.670 of how repackaging corporate bonds, and things 00:46:00.670 --> 00:46:03.610 like mortgages, auto loans, and other securities, 00:46:03.610 --> 00:46:05.980 could actually lead to some very, very 00:46:05.980 --> 00:46:11.200 attractive securities for a variety of different clientele. 00:46:11.200 --> 00:46:14.800 For equity securities, we applied exact same framework 00:46:14.800 --> 00:46:18.370 to try to come up with a value of a future stream 00:46:18.370 --> 00:46:19.480 of dividends. 00:46:19.480 --> 00:46:22.930 And here, while the mathematics was pretty similar, 00:46:22.930 --> 00:46:25.210 the interpretation differed in an important way, 00:46:25.210 --> 00:46:28.420 because dividends are random, whereas, in the case of bond 00:46:28.420 --> 00:46:32.110 prices, the coupons are known in advance. 00:46:32.110 --> 00:46:35.730 So that's the difference between fixed-income securities, where 00:46:35.730 --> 00:46:38.560 the incomes are fixed in advance, 00:46:38.560 --> 00:46:41.590 versus equity securities, where there's randomness. 00:46:41.590 --> 00:46:43.600 What that randomness does is to make 00:46:43.600 --> 00:46:46.850 the volatility of these pricing models much greater. 00:46:46.850 --> 00:46:48.790 In other words, it's harder to pin down 00:46:48.790 --> 00:46:50.980 what the price of an equity security 00:46:50.980 --> 00:46:53.380 is, because in addition to all of the risks 00:46:53.380 --> 00:46:54.839 that a bond will face-- 00:46:54.839 --> 00:46:57.130 in other words, the risk of future changes and interest 00:46:57.130 --> 00:46:57.880 rates-- 00:46:57.880 --> 00:47:01.240 you get the risks of changes in dividends, earnings, 00:47:01.240 --> 00:47:03.290 cash flows, and so on. 00:47:03.290 --> 00:47:06.160 We also talked about valuing companies 00:47:06.160 --> 00:47:09.250 using various different formulas, and then the idea 00:47:09.250 --> 00:47:12.640 behind PVGO, the present value of growth opportunities, 00:47:12.640 --> 00:47:15.850 and how that can actually lead to some tremendous valuation 00:47:15.850 --> 00:47:21.300 swings in a company that's based upon intellectual property. 00:47:21.300 --> 00:47:23.705 We then talked about a whole other set of securities 00:47:23.705 --> 00:47:25.830 that most of you probably haven't come into contact 00:47:25.830 --> 00:47:29.270 with-- futures versus forwards. 00:47:29.270 --> 00:47:32.330 These are weird securities in the sense that they're 00:47:32.330 --> 00:47:37.100 worth nothing on the day that you agree to enter 00:47:37.100 --> 00:47:38.961 into one of these contracts. 00:47:38.961 --> 00:47:40.460 But the reason they're worth nothing 00:47:40.460 --> 00:47:43.430 is that these are bilateral agreements between two 00:47:43.430 --> 00:47:45.770 counterparties And so both of you 00:47:45.770 --> 00:47:50.360 are willing to enter into this in a willing exchange of cash 00:47:50.360 --> 00:47:52.522 flow payments sometime in the future. 00:47:52.522 --> 00:47:54.230 The only reason you're willing to do that 00:47:54.230 --> 00:47:57.950 is because the contract from an objective standpoint 00:47:57.950 --> 00:48:00.470 doesn't have any NPV. 00:48:00.470 --> 00:48:03.410 And we see that the marking to market of futures 00:48:03.410 --> 00:48:05.600 makes a very big difference in terms 00:48:05.600 --> 00:48:08.480 of the liquidity characteristics of that contract. 00:48:08.480 --> 00:48:11.540 We see that today with what's going on in financial markets-- 00:48:11.540 --> 00:48:14.510 and that using these contracts both for hedging purposes 00:48:14.510 --> 00:48:17.960 and for speculation is a very key aspect 00:48:17.960 --> 00:48:21.430 of this whole industry. 00:48:21.430 --> 00:48:22.710 Question? 00:48:22.710 --> 00:48:23.210 Zeke? 00:48:23.210 --> 00:48:25.350 Oh, okay. 00:48:25.350 --> 00:48:28.800 Then the last set of securities that we spent time 00:48:28.800 --> 00:48:30.600 on in this course, is options. 00:48:30.600 --> 00:48:33.420 Options are different from anything else 00:48:33.420 --> 00:48:35.250 we've looked at up until now, because first 00:48:35.250 --> 00:48:40.170 of all, their payoffs are asymmetric; they're kinked. 00:48:40.170 --> 00:48:42.420 And by putting together a portfolio of options, 00:48:42.420 --> 00:48:44.340 we can get all sorts of weird payoffs. 00:48:44.340 --> 00:48:47.820 In fact in the various different exam 00:48:47.820 --> 00:48:49.680 questions that you might get, you 00:48:49.680 --> 00:48:53.750 will be asked to try to come up with different kinds of payoff 00:48:53.750 --> 00:48:54.660 structures. 00:48:54.660 --> 00:48:56.700 So you need to know a little bit about how 00:48:56.700 --> 00:48:58.440 to put these things together and what 00:48:58.440 --> 00:49:00.840 the various different payoffs imply 00:49:00.840 --> 00:49:02.700 under different circumstances. 00:49:02.700 --> 00:49:06.390 We also gave you a very simple example of an option pricing 00:49:06.390 --> 00:49:10.200 strategy, a model, namely, the binomial pricing model. 00:49:10.200 --> 00:49:12.960 Very simple, but it's actually one of the most heavily used 00:49:12.960 --> 00:49:14.430 in industry. 00:49:14.430 --> 00:49:18.840 And it's an extraordinarily flexible and powerful method, 00:49:18.840 --> 00:49:24.060 again, based on the principle of arbitrage, or no free lunch. 00:49:24.060 --> 00:49:28.590 We then started introducing risk into the picture explicitly. 00:49:28.590 --> 00:49:31.980 We talked about the size effect, January effect, value line, 00:49:31.980 --> 00:49:36.780 momentum, accruals, and pointed out that all of these effects 00:49:36.780 --> 00:49:40.140 can lead to certain investment strategies. 00:49:40.140 --> 00:49:42.300 Whether or not the strategies are good or bad 00:49:42.300 --> 00:49:43.640 really requires a framework. 00:49:43.640 --> 00:49:45.722 We didn't have a framework at the time. 00:49:45.722 --> 00:49:47.430 But I wanted to point out these anomalies 00:49:47.430 --> 00:49:50.160 to just mention that they are the basis 00:49:50.160 --> 00:49:52.500 for a number of investment products and ideas 00:49:52.500 --> 00:49:53.610 over the years. 00:49:53.610 --> 00:49:56.880 And so we really need to have a systematic way of thinking 00:49:56.880 --> 00:49:59.730 about how to evaluate not only these strategies, 00:49:59.730 --> 00:50:01.410 but the managers that tout them. 00:50:01.410 --> 00:50:03.090 Are they adding value? 00:50:03.090 --> 00:50:06.120 Or is this something that really you could do for yourself? 00:50:06.120 --> 00:50:10.200 So we developed this notion of not so much picking 00:50:10.200 --> 00:50:13.890 a stock, or a good two or three stocks, 00:50:13.890 --> 00:50:16.890 but putting together a whole collection of stocks, 00:50:16.890 --> 00:50:18.850 a good portfolio. 00:50:18.850 --> 00:50:23.490 And we zeroed in on mean and variance as the key concepts 00:50:23.490 --> 00:50:27.000 to evaluate what is good and what is not good. 00:50:27.000 --> 00:50:33.180 And we deduced the main result of finance theory 00:50:33.180 --> 00:50:36.600 under uncertainty, which is the capital asset pricing 00:50:36.600 --> 00:50:38.850 model in two forms-- 00:50:38.850 --> 00:50:42.090 the capital market line for efficient portfolios, 00:50:42.090 --> 00:50:46.230 and the security market line for any kind of security 00:50:46.230 --> 00:50:49.360 or portfolio, whether it's efficient or not. 00:50:49.360 --> 00:50:52.980 And this allows us to resolve the open question 00:50:52.980 --> 00:50:55.050 that we started with, which is, how do we 00:50:55.050 --> 00:50:58.590 determine what the appropriate risk-adjusted discount rate is? 00:50:58.590 --> 00:51:01.260 I've said at the very beginning, let the market determine it. 00:51:01.260 --> 00:51:03.840 This allows us to explicate how it 00:51:03.840 --> 00:51:09.210 is that the market might go about doing so, assuming 00:51:09.210 --> 00:51:11.220 rationality. 00:51:11.220 --> 00:51:14.730 If people aren't rational, this goes out the window. 00:51:14.730 --> 00:51:17.790 But assuming that they are, this is a complete theory 00:51:17.790 --> 00:51:20.910 for how you determine risk and expected return. 00:51:20.910 --> 00:51:24.190 And using risk an expected return, 00:51:24.190 --> 00:51:27.510 we now have a complete theory for capital budgeting, 00:51:27.510 --> 00:51:31.140 for how to evaluate whether or not you ought to take a project 00:51:31.140 --> 00:51:33.840 or not take a project, OK? 00:51:33.840 --> 00:51:36.870 And last and certainly not least, 00:51:36.870 --> 00:51:40.080 we talked about the idea behind market efficiency, the idea 00:51:40.080 --> 00:51:43.630 that you can actually trust market prices, market rates 00:51:43.630 --> 00:51:47.340 of return, market betas, all of the information that you 00:51:47.340 --> 00:51:51.180 glean from market data and apply them to your decisions. 00:51:51.180 --> 00:51:52.960 Can you trust them? 00:51:52.960 --> 00:51:55.170 And the answer is sometimes. 00:51:55.170 --> 00:51:57.330 When markets are efficient, when prices fully 00:51:57.330 --> 00:51:59.580 reflect all available information, 00:51:59.580 --> 00:52:02.340 the power and the wisdom of crowds 00:52:02.340 --> 00:52:03.930 is very, very compelling. 00:52:03.930 --> 00:52:07.560 But there are periods where the crowd is not 00:52:07.560 --> 00:52:11.260 a wise crowd, but an angry mob, like right now. 00:52:11.260 --> 00:52:13.710 So you want to be careful and not talk to the market 00:52:13.710 --> 00:52:16.230 about evaluating your project when they're 00:52:16.230 --> 00:52:19.020 trying to lynch somebody or some financial institution that's 00:52:19.020 --> 00:52:21.120 out there, OK? 00:52:21.120 --> 00:52:24.180 And in order to reconcile efficient markets 00:52:24.180 --> 00:52:28.260 with these periods of insanity, I 00:52:28.260 --> 00:52:30.540 proposed this notion of adaptive markets. 00:52:30.540 --> 00:52:34.020 And at least it provides a consistent framework 00:52:34.020 --> 00:52:37.860 for thinking about these periods of craziness, 00:52:37.860 --> 00:52:41.670 as well as periods of market calm. 00:52:41.670 --> 00:52:42.960 So that's it. 00:52:42.960 --> 00:52:45.210 That's it for 15.401. 00:52:45.210 --> 00:52:47.640 Where you go from here depends upon what 00:52:47.640 --> 00:52:49.710 your career objectives are. 00:52:49.710 --> 00:52:54.170 If you're interested in pursuing investments, 00:52:54.170 --> 00:52:56.970 if you want to be a trader, a portfolio manager, 00:52:56.970 --> 00:53:01.920 or get involved in pension asset management, what you want to do 00:53:01.920 --> 00:53:04.710 is to focus on the investments direction, things 00:53:04.710 --> 00:53:10.560 like 15.433 Investments, or 15.437 Options and Futures. 00:53:10.560 --> 00:53:14.400 And we have a number of practical pro seminars 00:53:14.400 --> 00:53:15.900 that are taught by practitioners, 00:53:15.900 --> 00:53:18.840 like Seth Alexander, the current Chief Investment 00:53:18.840 --> 00:53:22.530 officer of the MIT Endowment, or Phil Cooper, former partner 00:53:22.530 --> 00:53:25.170 of Goldman Sachs who has his own private equity company. 00:53:25.170 --> 00:53:28.080 There are a number of these practitioner courses, 00:53:28.080 --> 00:53:30.570 as well as the theoretical courses 00:53:30.570 --> 00:53:33.450 that we offer that I would encourage you to take. 00:53:33.450 --> 00:53:35.730 If, on the other hand, you're looking 00:53:35.730 --> 00:53:40.890 for something on the corporate financial side-- 00:53:40.890 --> 00:53:45.570 project finance, corporate financial management, 00:53:45.570 --> 00:53:48.540 that kind of approach requires that you learn more 00:53:48.540 --> 00:53:51.340 about capital budgeting, mergers and acquisitions, 00:53:51.340 --> 00:53:54.930 corporate finance, so 15.434 is a good course, 00:53:54.930 --> 00:53:56.730 and certain accounting courses. 00:53:56.730 --> 00:53:59.220 You might want to take financial accounting. 00:53:59.220 --> 00:54:00.630 Those are the directions that you 00:54:00.630 --> 00:54:03.060 may want to take if you're interested in pursuing 00:54:03.060 --> 00:54:05.160 that career path, 00:54:05.160 --> 00:54:08.850 So both of them I think are extraordinarily exciting. 00:54:08.850 --> 00:54:11.040 They all rely on the material that we've 00:54:11.040 --> 00:54:12.540 covered in this course. 00:54:12.540 --> 00:54:16.530 And so, you know, you now have the background 00:54:16.530 --> 00:54:20.270 to be able to handle any and all of that material.