This post was originally published on this site
The phrase “it’s different this time” has a bad reputation in financial circles.
It’s often the tag line for bullish investors who dismiss stock-market warning signals to their own detriment. Take the late 1990s, the critics will say. Many believed then that the internet would change the world. It did, sure. But the sector still had just as many losers as winners. Investors dismissed sky-high valuations—it really is different this time, they said—only to see the market crash in 2000.
The phrase, however, or at least its context, is misplaced, argues economist and author Andrew Lo. It is indeed different this time, he says—things are likely worse than history would belie.
In fact, financial markets have evolved to the point that some of the old investment “truths” are decidedly less “true” then they were. And all of this makes investing a lot harder, he says.
Lo, director of the MIT Laboratory for Financial Engineering and a leading authority on behavioral finance, has been working on a new theory that explains how markets work: Adaptive Market Hypothesis.
He views financial markets as a constantly evolving ecosystem in which market participants are changing and adapting to their environment, which itself is evolving due to new technology and innovation, new rules and regulations, as well as shifts in investor behavior.
In his book, “Adaptive Markets: Financial Evolution at the Speed of Thought,” Lo describes aspects of the market that have changed over the past few decades, changes that should prompt a new look at the traditional investment paradigm.
Looking at five-year rolling compounded returns of the U.S. stock market and volatility, Lo observes a clear shift to a more volatile period beginning in the mid-1990s. Since then, volatility in the stock market has gone up substantially. Even though bear markets—a downturn of 20% or more—happen every five years on average, the last two were so big that they shaped and defined an entire generation’s risk tolerance and attitudes toward investing.
Instead of being rewarded for taking risks in late 1990s and leading up to the financial crisis, investors got punished.
According to a recent survey from Legg Mason Global Asset Management, the vast majority of millennial investors have been influenced by the financial crisis and subsequent Great Recession, leaving them more risk-averse than any other age group.
“Some of the largest levels of volatility were reached during the financial crisis in 2008, in fact [the CBOE Volatility Index, or VIX VIX, -2.22% ] reached as high as 80 in October of 2008 and has come down ever since,” Lo said. “But nevertheless the volatility of volatility has gone up in the sense that volatility slings have become much wider and much more frequent … We know VIX can spike very quickly if, say, North Korea launches a missile.”
Increased volatility has violated one of the main principles of the risk-reward tradeoff, according to Lo.
“In times of crisis the traditional positive association between risk and reward is violated as investors act irrationally and taking risk is punished instead,” Lo said.
“Stocks for the long run still offer good returns if held for multiple decades,” Lo said, “but over more realistic horizons, such as five years, the chances of loss are significantly greater.”
Technological advances and popularity of index funds have changed how investors view passive investing, but that still has not changed the riskiness of these assets, according to Lo.
“Investors need to be more proactive about managing their risk,” he said.
Resurgence of new financial institutions, such as high-frequency traders and quant hedge funds that operate across national borders, created links and contagion across previously unrelated assets, according to Lo. The implication is that asset allocation is no longer as effective at managing risk as it was during the previous eight or so decades.
So, it is different this time. Adjusting expectations and being prepared for swings is more important than ever.
“You can still count on diversification. But you have to work harder for it,” Lo said. “In other words it’s not enough to diversify between domestic stocks and bonds, you’ve got to go international and you’ve got to go across not just stocks and bonds, but stocks, bonds, currencies, commodities and other asset classes.”