MIT’s Andrew Lo Advises Diversifying Across Asset Classes

By on February 29, 2012

Andrew Lo - MIT Sloan School of ManagementIn the latest edition of WealthTrack, Consuelo Mack interviewed MIT Sloan School of Management Professor of Finance and money manager Dr. Andrew Lo.

Lo began the interview with a discussion of market volatility by stating political instability was the biggest source of systemic risk hanging over the market with the implications of Dodd-Frank and the situation in Europe needing to be worked out. Lo added it would probably take 2-5 years to see any differences.

Lo said the U. S. won’t see any movement until after the 2012 elections and policy will take a couple more years after that with the implications of Dodd-Frank and the Volcker rule not becoming clearer until then.

Lo stated Europe will be a “slow burning fuse” which could come to a head this year, but more than likely, they will be able to push it off.

Lo said what we need to be worried about is the “volatility of volatility.” The idea behind this is that we’re really on a volatility roller coaster. During times when markets look calm volatility will be low. The VIX will be in a reasonable range of 15-20%. But within a matter of days after any political change we may see that volatility going up to 25-50, or 60%. At 60% volatility investors are going to have to be very careful about what’s going on in their portfolios.

When asked by Mack if there were some new rules investors should apply to their portfolios, Lo responded there were definitely new rules and he would focus on three.

Markets are not stable and can change at the drop of a hat so we have to be more active about managing our risks, Lo said. A case in point being volatility. He said historically an investor would have a 60% stock/40% bond portfolio which would see the portfolio experience 10-11% volatility in a year. In the current environment this portfolio can now have 30-40% volatility, which are swings “no investor has signed up for.” Lo’s first new rule is that investors have to more active in managing risks and being aware of those risks.

Lo’s second rule is what he calls, “Diversification Deficit Disorder.” The interview continued with Lo’s discussion of importance of adequate diversification across different asset classes, becoming more educated about our own finances, his Adaptive Market’s Hypothesis versus the Efficient Market Hypothesis, the questions investors should ask about their own portfolios, managing risk allocation as opposed to asset allocation, his managing of volatility on a daily basis through the use of futures to achieve a steady level of volatility of around 8 percent, the attractiveness of managed futures products as a non-traditional asset class, and the importance of paying attention to macro trends and reacting in a sensible way.

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