The Hindu Business Line : Investment Nuggets

As Harris and Harris Group Professor at Massachusetts Institute of Technology's Sloan School of Management and Director, MIT Laboratory of Financial Engineering, Dr Andrew Lo has had an admirable influence on scores of the "best and brightest'' students who have passed through its portals. The Laboratory of Financial Engineering is a partnership between academia and industry, designed to support and promote quantitative research in financial engineering and computational finance. Starting off with conventional research of developing models of financial markets, over the past few years, he has been involved in more esoteric roles such as exploring the role of emotions in risk based decision making by traders and use of sophisticated algorithms and neuroscience which will help investors make financial decisions.

"Financial engineering is a field that requires a strong background in a variety of disciplines. Probability, statistics, stochastic processes, economics, finance, and accounting are just some areas of required knowledge and expertise. So, my advice to students in the field is to spend time learning and mastering these disciplines; they will be the `tools' that any successful financial engineer will have at his or her disposal. A second piece of advice is to start reading the literature, academic journals and industry publications — for example, the Financial Analysts Journal, RISK magazine, and the academic finance journals. Third, there are several `classic' texts in the field that all students should be familiar with, even if they don't grasp all the concepts on a first or second read. These include Merton's Continuous Time Finance, Huang and Litzenberger's Foundations of Financial Economics", and Ingersoll's Theory of Financial Decision-Making, just to name a few.

— Advice from Mr Andrew Lo for a budding financial engineering student. Published in the International Association for Financial Engineers, the year in which he was awarded the 2002 Sungard/IAFE Financial Engineer of the Year.

The Internet is going to have a profound effect on the field, especially for retail investors. Financial institutions will be able to provide investors with a large set of customised products offering a wide range of risk-reward alternatives. This is going to create a need for advisors knowledgeable enough to help investors use these tools as part of a careful and sophisticated financial planning effort. Investment managers are also going to have to become more sophisticated in how (and when) they use new investment tools and products. If financial engineering today is synonymous with "risk management", in the future it will become synonymous with "wealth management".

Contrarians think that prices overreact— that what goes up must come down and vice versa— so buying the losers and selling the winners can be profitable. But the existence of cross-week predictabilities provides another source of contrarian profits. To see this, consider a stock market with only two stocks, A and B, and let A and B have positive cross-week correlations. Suppose A is up this week and B is down; a contrarian would then sell A and buy B. But when there's positive cross-week correlation, an up-week for A implies an up-week for B next week, and a down-week for B implies a down-week for A next week, hence a contrarian profits from both positions — but it's because of these cross-stock predictabilities, not overreaction. If you are trading 150 stocks simultaneously, it's much more complicated to take into account all of these possible cross effects — there are some real combinatorial challenges involved. That's what D. E. Shaw does so successfully: it uses various computational algorithms to optimise these sorts of trades. Nowadays, there are many more sophisticated varieties.

— From Derivatives Strategy magazine

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