Andrew Lo, Efficient Markets and Risk

During my MBA program, I took a class called Applied Investment Management ( where we managed part of Notre Dame’s endowment.  As part of the class, I wrote this essay on efficient markets which I have adapted for my blog.

            One of the most common descriptions of markets derives from Adam Smith who described markets as moving toward equilibrium prices as if guided by an “invisible hand”.  While this is a powerful metaphor, the reality is that markets are not magical institutions that output correct prices if the right conditions are met, but that they are human institutions that succeed despite our being irrational animals with biases and fears designed to survive in the plains of Africa and not the complex modern world that we inhabit.  These manifest themselves in both our investing behavior and in the large scale structure of markets. Ultimately, though, markets work well and it is very difficult for anyone but the most talented and nimble investor to consistently achieve excess risk adjusted returns.

            One critical insight in considering the theory of market efficiency is the idea of how investors make choices.  The efficient market hypothesis is often criticized for claiming that all market participants are driven by rational expectations. However, it seems that bounded rationality is a more satisfying description of the decision making process (Lo, 2007).  I find Lo’s framework for incorporating bounded rationality into an evolving system of investor behavior to be intuitively satisfying. We all use short cuts (heuristics) to avoid having to consider fully all alternatives and weight them against each other and the biologic system gives the financial professionals a theoretical underpinning for what they have been doing their entire career.  Being self-aware of the short cuts that I use will allow me to better understand my own decision making process and give me an advantage over other market participants who are a prisoner of their biases.  In time, the mathematical model proposed by Lo may be able to provide a barometer of efficiency (“The market is 2% inefficient today”) that would be able to further improve my decision making.

            However, there may be a more radical implication of Lo’s Adaptive Market Hypothesis (AMH).  His framework seems to be able to explain why some strategies come into favor and they stop working for a time.  For example, a value investing strategy was not very profitable during the 2006 – 2008 time frames because the market lead all stocks to be overvalued. However, if we now know that there is a time in which strategies work and a time when they fail, it may be possible to beat the market and outperform the traditional buy and hold recommendation by continuously switching out of under-performing strategies and into outperforming strategies based on market conditions.  The counter to this is that the transaction costs and fees may overwhelm any excess profits that can be extracted from doing so (Malkiel, 2003).  I am more optimistic than Malkiel is largely because of the thriving hedge fund industry.  With a small enough fund, say $500 million, you may be nimble enough to move in and out of positions profitably but large enough to hold down transaction costs with your prime broker.  In addition, institutional investors are not going to rationally agree to fees that leave them with no excess returns, so the net effect may be a fund that beats the markets on a fee, transaction cost and risk adjusted basis.

            Given the rarity of the ability for an investor to outperform the market, most any excess returns achieved by these super investors will likely be captured by the investor through fees charged to clients.  As a result, it is extraordinarily difficult for market participants to exploit these inefficiencies and the standard buy and hold strategy remains the most appropriate. However, there is still hope for active managers of money.  The patient and disciplined investor, aware of the biases in his decision making process and the cycles related to various investment strategies, should be able to achieve excess returns periodically and add value to money entrusted to them by their clients.  This method of investing is challenging and will likely be difficult to replicate consistently, but I believe that is what makes the investment management industry so rewarding.


Lo, A. W. (2007). Efficient Market Hypothesis. In L. B. Durlauf,The New Palgrave: A Dictionary of Economics. New York: Palgrave McMillan.

Magin, J. B. (2009). The U.S. Equity Return Premium: Past, Present and Future. Journal of Economic Perspectives, 193-208.

Malkiel, B. G. (2003). The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives, 59-82.

The Next Tech Turnaround

I am going to work on blogging more regularly.  With all of the talk of the trouble at Yahoo, I have been thinking about major turnarounds in the fortunes of technology giants.

Some of the most inspiring corporate successes have come as a result of a turnaround from a dire situation and the technology industry has had two great ones in the last twenty years.  First, the pinnacle of 20th century technology, IBM, had to pivot from a mainframe and hardware company to a software and services company.  Second, Apple rose from near bankruptcy to become one of the largest and most profitable companies in the world.  As social, mobile and analytics spread turmoil through the tech world, here are some new candidates for a grand reprise.

  • Microsoft - Windows, Office and Server
  • Sony - Consumer products, movies, music and gaming
  • AOL - Content generation and advertising
  • HP - Printers, PC’s, servers and consulting
  • RIM - Enterprise smartphones and BBM
  • Yahoo - Consumer websites, messaging and advertising

In each company there has been a combination of management turmoil and a lack of a coherent direction for their products.  On the positive side these companies continue to generate cash from their legacy businesses that can finance a turnaround and find a new product direction.  I believe that the most likely candidate to accomplish this is Microsoft.

During the 90’s, Microsoft achieved its goal of putting a computer on every desktop and then didn’t know what to do next.  After drifting for the better part of a decade, its product strategy appears to be coalescing around three principles:

  1. Unified development environment and design language from phones to servers
  2. Natural user interfaces (NUI) via Kinect including touch, speech and gestures
  3. Cloud services as the primary delivery vehicle

Coming this fall, both Windows 8 and Windows Phone 8 will (probably) allow for a common code base with  different user interfaces and it is likely that it will soon extend to the Xbox.  This scenario will likely be very attractive for developers. The most controversial aspect is the Metro interface on the desktop.  I have been using the preview for several months and I like it a lot, but Metro is not ready to replace the desktop for power users.  However, the most critical need is for mobile and tablet devices to be competitive and I feel that will be achieved.  In the meantime, businesses will continue to run Windows 7, as many of them are just now upgrading, and jump on board Metro in Windows 9 once it is ready for them.

The natural user interface improvements using Kinect technology is an under-appreciated improvement and it could be the killer app that shifts consumer adoption back to Microsoft ecosystem.  If laptops include 3D cameras that allow for well functioning gesture, face and voice recognition, I would certainly consider upgrading.  I don’t think Microsoft even realized how popular this would be.

Lastly, much of the Office suite is moving online through Office 365, which is priced very aggressively against Google Apps.  A small business can get hosted versions of Exchange, SharePoint and Messaging for only $6 per month per user whereas it would have cost thousands of dollars per year in the past for servers and employees (ie unaffordable).  Office is the standard for office productivity and if Microsoft includes delivery it on all mobile platforms (iOS and Android) as seems likely, it will remain the leader and continue to generate enormous profits.

As a result, I believe that Microsoft is in the best position of the previous generation to return to technology leadership by focusing their product strategy around SaaS, mobile, ease of development and natural user interfaces.

When all enjoy equal freedom and our interactions are voluntary, the result is not chaos, but order; not poverty, but plenty; not conflict, but cooperation.

Frederic Bastiat 

Working in Venture Capital

I was recently contacted by a student about advice in how to get a job in venture capital.  He found it helpful and I decided to post is so that others could benefit from it.

There are a few things to do.  The easiest is to create updated social media profiles (LinkedIn, Twitter) and consider starting a blog.  This is a good way to establish your online identity and the fact that you are engaged with current technology.

The second is to keep up to date on fundings and start-up.  A VC interview will often include discussion about which recently funded companies you are most interested in, your favorite early stage start up, the trends in major segments like social CRM or mobile.

Some good resources are:

Another strategy is to track firms that are funding companies you are interested in and start to build a relationship with them.  For instance, if they fund a company you really like, tweet the VC that you think it is great.  Write a blog post on how you use the service or maybe one about the best companies in that segment and the VC’s that are funding them.  Build up a base of credibility.

Other than that, go to start-up events in the area that you are living and see if you can work with one part time as they get off the group.  In order to advise start-ups you should be able to relate to them in some way.  If you are not a coder, at least you can say, I was there with when they developed their business model and I understand how hard it is.  This is not a job per se, but just getting involved in the community.

This is all to say that by the time you look to get to the point of trying to get a job at a VC, you will be able to tell a story about why you are the best person to build relationships with entrepreneurs, evaluate deals, and work to support the firms portfolio companies.

One additional note, VC’s tend to hire when they raise funds, so keep an eye out for that.

The end result of this is that you will be able to get an introduction to partners at funds and be able to talk to them as if you already worked there.

Information Arbitrage: The Entrepreneur/Investor Covenant


Starting a company is really, really hard. Helping entrepreneurs start and build companies is really, really hard. Much has been written about the mechanics of entrepreneur/investor interaction, from how to pitch investors, structure the round, assemble board decks, undertake strategic planning,…

Personal Resposibility and Capitalism - Guest Post

My good friend, Cait Sheridan, shared this with me and I felt others might find it thought provoking and interesting.  Enjoy.


The two worst concepts ever to happen to capitalism are (in no particular order) “caveat emptor” and “consumer protection”.  One implicitly gives business permission to misbehave, while the other implicitly gives consumers permission do the same.  Either alone is dangerous, the two together are havoc.  Each exonerates one side of a business transaction or the other from culpability. The net effect of the two combined is that nobody involved in any business transaction has any responsibility over the outcome.  
The solution to America’s current, rather angsty, attitude toward capitalism (among many of America’s other problems), is simple.  First, we need to remember that all organizations and “their” actions are really nothing but the concerted efforts of individual people.  Then, we need to reshape society’s expectations such that all people are held to the same 4 basic principles in ALL aspects of their lives, even when working in concert with others:

  • Personal responsibility
  • Integrity
  • Honesty
  • Courtesy

 I expect that the most automatic reaction against this is, “what about the people who defect and don’t live up to these expectations?”
I say, “what about them?”  These people will always exist, but they are always the minority.  If a consumer is living up to these principles, he is not only representing himself honestly to the business, he is also protecting himself from a possible defector on the business side of the transaction by being responsible for his own due diligence.  Likewise, if the individuals working in organizations live up to these standards, then they are a) neither behaving abusively nor deceptively toward consumers, and b) they are protecting the business from a possible defector on the consumer side by performing their own due diligence. The net effect is that at least one side in any transaction is behaving responsibly most of the time.
I’m not saying that there won’t be times when all involved are defectors, but these would be “tail” events, and – if all parties are behaving irresponsibly anyway, then they all deserve the havoc they get.
I’m also not saying that there won’t be times when even the most diligent individual(s) fail to protect themselves in the event of a defector. These are the events for which statutory intervention are intended. Granted, we all know this has its own problems, but that’s an issue to tackle for another day. Nevertheless, like the scenario in which all parties are defectors, these would be “tail” events. 

In the end, if we hold ourselves and each other to these standards, we can all have a happier, healthier relationship with capitalism, which means we can all reap more of its economic benefits.

Government, Debt and Uncertainty

It is funny that this blog, ostensibly about finance and economics, has really been about my thoughts on careers and my job search.  In order to rectify that, I want to bring your attention to one of the best commentators on the economy that I read, John Mauldin (

The economy is destined to be the overwhelming issue of debate this November with American angry about a lack of jobs, government spending (either too little or too much), government debt and economic growth.  While I am of the opinion that the best way to restart economic growth is to decrease the participation of the public sector in the economy and reduce the crowding out effect, Mr. Mauldin makes an interesting point with regards to the challenges of doing so.

…the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. Yet the whole world cannot run a trade surplus. 

The private sector is deleveraging due to the recent credit crisis and our trade deficit has actually gotten worse recently.  Therefore…

If we want to reduce the deficits AND reduce our personal debt, we must then find a way to reduce the trade deficit, which is running about $500 billion a year as we write, or about $1 trillion less than the deficit.

If the US is going to really attempt to balance the budget over time, reduce our personal leverage, and save more, then we have to address the glaring fact that we import $300 billion in oil (give or take, depending on the price of oil).

As a result, I believe that the creation of a new energy policy will be one of the greatest challenges for Congress in the next several years.  While it is often said that the US does not have an energy policy, I think we actually have a very clear one.  Keep the oil producing regions dependent enough on us through aide, oil revenue or security so that, even if they don’t like us, it is in their best interests to keep selling us oil.

While there are many good suggestions on how to reduce our dependence on foreign oil, it concerns me greatly what would happen to the oil producing regions if their declining revenues lead to social instability.  There are millions of poor, young and unemployed people who currently rely on the generosity of the government to feed themselves and their families.  If the government is no longer able to do so, then revolution with a very uncertain outcome may result.

I believe that the next Congress will tackle this critical problem, but I hope they give serious thought to the unintended consequences that may result.

Career vs. Job

Edit: This post was accidentaly deleted and recovered thanks to the wonders of Google.

I have been remiss in blogging as I had the good fortune to find employment. Having done so, I have been thinking about what it means to have a career versus a job.  The last two years, while nominally called business school, were really just very expensive unemployment financed with federal loan guarantees predicated on the hope that I would get a job to pay them back.  However, I, along with most of my classmates, wanted more.  We wanted a career, something that will hopefully give us a sense of purpose rather than simple remuneration.

Since many people looking for a job struggle to identify what their careeris, I have come up with a rubric that has worked for me and may allow others to avoid mistakes.

If you think you have found a career, ask yourself three questions:

1. Are you actually good at (or can be in the near future)?

People with a good personality or through sheer determination may be able to talk themselves into a wide range of jobs because the reality is that it is almost impossible to get to know much about a person during the interview process.  For instance, a person who hates Excel may be able to get a job in finance.  This would be a huge mistake as you will spend the first several years living in Excel.

2. Will anybody pay you to do it at a level sufficient to support your lifestyle?

It is really the second part that is most important.  If you are happy living out of a tent and eating ramen noodles, then most any job will do.  However, you may want to buy a house, travel, pay for your kids’ college and these costs really add up.

3. Is it something you enjoy?

This is the one that is most likely to get left by the wayside.  People can do jobs they hate for an amazingly long time.  The danger here is that, if you don’t at least derive a modest level of enjoyment from it, you will probably not hustle as much, keep up to date with the latest trends and build a large professional network in that field.  Therefore, when the axe comes in ten or twenty or thirty years and you are unemployed, it will be very difficult to find a new job.  Only take a job you don’t enjoy if it is on the path to one that you DO.

If your chosen career allows you to answer “yes” to each of these questions, then CONGRATULATIONS!  You have found the right job. 

If not, here are some scenarios to consider:

Yes Yes No

A very common and tempting situation especially if you are in need of money.

Try to understand if it will allow you to get to a position that will let you answer yes to those questions.  You may need to be patient, but if you are on the right path, hustle your tail off and make it happen.

Yes No Yes

So you want to be a poet?  I would really consider making this a hobby and finding something else for a job.  Remember, having sufficient financial resources gives you the freedom to pursue a wide range of interests and volunteer opportunities.

No Yes No

I would question why somebody wants to hire you to do this.  Be very cautious.

I hope this brief guide to finding a career is helpful and wish everybody who is not yet able to answer yes to those three questions the best of luck.

What we do online is something quite different: we curate our private lives for public exposure.

Taking Risk - Going Beyond Your Comfort Zone

My boss once asked me, “What is the dumbest thing you have ever done?”.  His point was that I have always been very deliberate in making decisions in my career.  This is not to say that decisions I have made have been easy or simple.  In retrospect, a person’s career often appears to be a set of logical steps that led them to their current position.  What that narrative does not include are all of the opportunities that were passed on, the interviews that went nowhere and the positions they didn’t get because they really weren’t the right fit.

Where then is the risk, if it is all a random walk?  The hard part is choosing a job that pushes you beyond your comfort zone, where you have butterflies when you show up for the first day of work, and also gives you the visibility and additional skills that allow you to take increasingly senior positions in your chosen field or industry.  There is no guarantee that any of this will happen, hence the risk, and that leads many people to take jobs where they will be comfortable and the likelihood of failure is minimized.

The difficulty with that strategy is that, when the times get tough, as they recently have been, and you find yourself out of work, as most everybody will at some point in their career, it will ironically be much harder for you to find another position.  While you may have been very successful and quite good at your job, the net result is that there is very little that distinguishes you and your skill set is a commodity.  Just when you need everything working in your favor, you will be required to rely disproportionally on your personal and professional network to find your next position.

Therefore, don’t be afraid to take the slightly off the wall job that may lead you in an unexpected direction.  It is my willingness to put myself outside my comfort zone and take prudent risks that has allowed me to keep developing as a professional.  As a real life example, I am faced with an opportunity that did not exist a week ago and which will lead my career in a new and interesting direction.  I am both excited and nervous, which tells me it is probably the right decision.

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