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Good Bye, Ivory Tower


Cover Story: Finance Stars: Academics

GOOD-BYE, IVORY TOWER

Theory takes a backseat to practical applications for many of today's young academics. Using studies of risk, human behavior, and market microstructures, these academic finance and economics stars are busily formulating better compensation plans and savvy ways of beating the stock marketReturn to top

ANDREW LO

Professor of Finance, MIT

How do people decide where to invest, and why do they make mistakes? That question, among the most vexing in all of finance, is the research focus of Massachusetts Institute of Technology Professor Andrew W. Lo, 37.

You could make billions of dollars if you knew the answer to Lo's question. But he says he's studying the problem for "less pedestrian" reasons than merely devising new moneymaking strategies. For one, it could hold significant implications for policymakers responsible for regulating the world's financial markets. It could also help the growing number of people who are directing their own retirement plans. "It's important to understand how people perceive risk, and how that translates into investment behavior," says Lo.

His latest research involves an experimental Internet-based trading game designed to analyze how investors react to a mythical futures market on monthly employment figures (http://cyber-exchange.mit.edu). So far, the research points to two important lessons. First, capital-gains taxes are bad because "they prevent investors from rebalancing their portfolios," he says. In addition, Lo thinks regulatory agencies should educate consumers about market risk. "Maybe we should teach schoolchildren probability theory and investment risk management," he says.By Geoffrey Smith in CambridgeReturn to top

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ROBERT VISHNY

Professor of Finance, Univ. of Chicago Business School

Academics have long argued that the market is too efficient for anyone to consistently beat, say, the Standard & Poor's 500-stock index. Indeed, index-fund investing stems from this "efficient market" hypothesis (EMH), and the University of Chicago Graduate School of Business is the theological center of this belief. That makes Robert Vishny, 38, a finance professor there, a heretic. He believes you can beat the market, and he's even a partner in an investment firm that has been doing it.

Vishny says that much of the movement in stock prices can better be explained by behavioral psychology than by EMH. For instance, he says there's a human tendency to believe that a pattern once identified, such as a company's years of ever-increasing profits, will go on indefinitely. "There's a human desire to hold on to already established opinions," he says. The result: Risk and value are often misjudged by the crowd, and smart investors can exploit that tendency.

The investment firm, LSV Asset Management, founded by Vishny and two collaborators, Josef Lakonishok of the University of Illinois and Andrei Shleifer of Harvard University, puts his ideas into practice. Since its 1994 launch, LSV has outperformed the S&P 500 by 3.4 percentage points annually. Vishny is the first to note that LSV's track record is too short to be able to determine whether he and his partners are smart or just lucky.

Vishny says he eventually will take his investment theories abroad as well. Investors, he says, "would be inclined to act the same way in all countries."By De'Ann Weimer in ChicagoReturn to top


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