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MIT's Lo Urges Flexibility in Asset Allocation Strategies

"When the facts change," economist John Maynard Keynes once famously told a reporter, "I change my mind." Given that life is full of change-in our personal financial circumstances, in our attitudes toward risk, in the economy and in the financial markets-it makes sense that investors should be prepared to change their asset allocation strategies, too, says Andrew Lo, Harris & Harris Group Professor of Finance at MIT's Sloan School of Management and Director of MIT's Laboratory for Financial Engineering.

Lo's seemingly common-sense conclusion is actually predicated on voluminous academic research and analysis, yet it remains highly controversial in the world of popular finance. For most of the past two decades, financial consultants have been advising investment pros and novices alike that the most sensible way to invest is to decide how much to allocate to stocks, how much to bonds and how much to other asset classes-all based on the investor's long-term investment objectives and tolerance for risk-and then stick to that asset allocation policy through thick and thin.

Speaking at the SVIA's 2003 National Forum, Lo argued that this timeworn "buy and hold" strategy is less than ideal because it does not allow investors to factor into their investment activities the real changes taking place in the world around them. While conceding that it can be extraordinarily difficult to predict which direction the stock market will move, he argued that it is possible to predict with some measure of success economic fluctuations such as business cycles, market liquidity cycles and market volatility cycles, and take them into account when making or revising asset allocation decisions. It is also evident, Lo said, that with stock prices subject to the whim and folly of human investors, stocks can from time to time become radically overpriced or underpriced relative to other asset classes. Failing to take into account those fluctuations in the equity risk premium-what investors are willing to pay for stocks relative to less volatile assets-just does not make sense, he argued.

What Lo has concluded through academic analysis many investors have concluded on their own over the past three years as they witnessed the bursting of the technology-stock bubble, which sent the entire stock market into a nose-dive. "Investors," Lo said, "have rediscovered risk." One consequence: they have a new appreciation for assets that can lower a portfolio's volatility, such as Stable Value funds.

In the end, Lo concludes, investing is all about survival, and adaptation and innovation are the keys to survival. Investors unwilling to be flexible in their asset allocation decisions may be hurting their chances of surviving in the investment jungle.

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