Andrew W. Lo

INTERVIEWER: Today is December 5, 2011. I'm Chris Boebel. As part of the MIT150 Infinite History project, we're talking with Professor Andrew Lo. Professor Lo is the Harris & Harris Group Professor of Finance at the MIT Sloan School of Management and the director of MIT's Laboratory for Financial Engineering.

His wide-ranging research interests include financial asset pricing models, financial engineering and risk management, trading technology, computer algorithms and numerical methods, financial visualization, hedge fund risk and return dynamics and risk transparency, and evolutionary and neurobiological models of individual risk preferences in financial markets.

His awards include-- to name just a few-- the Alfred P. Sloan Foundation Fellowship, the Paul A Samuelson Award, a Guggenheim Fellowship, and multiple awards for teaching excellence. He is a former governor of the Boston Stock Exchange and currently a research associate for the National Bureau of Economic Research, a member of the NASD's Economic Advisory Board, and founder and chief scientific officer of Alphasimplex Group, LLC a quantitative investment management company.

Professor Lo received a BA in economics from Yale University in 1980 and a PhD in economics from Harvard in 1984.

Professor Lo, thanks very much for coming in to talk to us today.

LO: Thanks for having me.

INTERVIEWER: So let's just start at the beginning. Where were you born, and where did you grow up?

LO: I was born in Hong Kong. And shortly after, I moved to Taiwan for about five years. And then, when I was five years old, I came to the United States. And I grew up in New York City.

INTERVIEWER: Tell me a little bit about that transition from a cultural perspective, that educational perspective.

LO: Well, it was a fantastic experience in many ways. So I grew up in a single-parent household in New York. And my mother worked pretty hard to put the three of the kids through school.

We went through public schools throughout, and the New York City public school systems are among the best in the country. Certainly, they were at the time, and so I feel I got a great education, and met some really, really interesting people during my time there.

INTERVIEWER: So you were an urban kid for most of your--

LO: I was. We lived in Queens, and I commuted to the Bronx. I went to the Bronx High School of Science. I'm very proud of that. I love that school, and I learned a great deal from my classmates. It was a lot of fun.

INTERVIEWER: So do you have very early memories from Taiwan? Or does your consciousness start in New York City?

LO: No, we have some memories. I've got a number of things that I remember well from those days: playing with fireworks was one of the favorite activities in Taiwan, but for the most part, my childhood was really in New York.

INTERVIEWER: So when did you start developing an interest in economics, math? I'm sort of interested in your entree to your field. Were there early signs?

LO: Well, actually, starting in high school. I had always been interested in science, of course. In third grade, my third grade teacher, Mrs. Barbara Ficalora, was wonderfully supportive, and made me the class scientist. And so I got an early introduction to doing experiments.

It wasn't until high school that I became exposed to real serious scientific reasoning, and also to the field of economics through a course that I took in social studies, where we read Heilbroner's Worldly Philosophers. And that really changed my thinking about the idea that you could apply interesting mathematical principles to problems in economics.

INTERVIEWER: Bronx Science is obviously kind of a legendary high school. Can you talk a bit more about your experience there? What were your career ambitions at that point in your life? And what kinds of things were you really studying in high school?

LO: Well, for me, Bronx Science was a really transformative experience, because, up until then, the junior high school and elementary school that I went to was really just local, kind of community schools, where you had a wide mix of kids, some of whom are interested in academics, but most of whom were probably not. And so in that kind of environment, to be doing well in school was to be a bit of an outcast.

It wasn't until I got to Bronx Science that it became cool to actually do well in school and to be interested in academics. So for me, it was really like an awakening. I had tremendous friends and activities in Bronx Science that I really couldn't have access to in any of the schools that I went to before that.

Also, for me, it was a little bit of an interesting experience in terms of the mathematics at Bronx Science. Right around that time, Bronx Science instituted-- as all New York City high schools-- the so-called New Math. And if you know the history of it, the New Math was an absolute disaster from the perspective of the majority of the students. But for me, it was actually transformative as well, because up until then, I had a particular learning issue, a slight case of dyslexia that we didn't know until much later on. And so for the longest time, I had difficulty with mathematical concepts, multiplication, and really basic things that other kids had no issues with. I had a hard time memorizing the multiplication table.

It wasn't until I got to Bronx Science that, because of the curriculum in mathematics-- it was transformed from the basic algebra, geometry, trigonometry to sets, rings, fields, abstract algebra-- that I turned from a C student to an A student in math, so for me, that was really an important experience.

INTERVIEWER: That's kind of an amazing story.

LO: I was one of the lucky ones that benefited from the unfortunate aspects of the New Math that was perpetrated on New York City high school students.

INTERVIEWER: At least there was one. So you mentioned your third grade teacher. Were there other mentors, significant teachers, experiences you had in high school or before that time that really pushed you in a certain direction?

LO: Oh, a number. One of the things that has always struck me is how important teaching is, because a good teacher can have such a positive influence on a student for the rest of his or her life. And similarly, a bad teacher can have tremendous negative consequences for that student. And so I've been very fortunate in that, during the years, I've had some good teachers, many good teachers, a few bad ones. So I have a good understanding of what's involved. And my third grade teacher, Mrs. Ficalora, stands out.

In high school, I had a number of teachers. Bronx Science is filled with really extraordinary faculty. In fact, we don't think of them as teachers. We think of them as faculty. Mrs. Mazen, my calculus teacher. I learned more from her about calculus than I think most college courses would teach their students. So there are a number of very talented instructors that I was very pleased and lucky to have.

INTERVIEWER: What were your career aspirations at that point, just before college?

LO: Well in high school, I think that most of my friends and I were interested in science and math. So at the time, my presumption was that I would go into one of those disciplines.

Being the youngest of three children, and having an older brother and sister that were also academically inclined made it relatively easy for me. My brother is a mathematician at the Jet Propulsion Lab at Caltech. And my sister is a biologist at the University of Pittsburgh. So they both followed very academic careers. And in my household, one had to get a PhD just to measure up to the older siblings.

So from high school on, I was very much interested in following some kind of a career path in academia, although my interests were somewhat on the more applied side, as opposed to purely theoretical kinds of issues.

INTERVIEWER: You mentioned a single-parent household. Was your mother at all academically inclined? Was it your mother that you were--

LO: Yeah, my mother was very much academically inclined, from the perspective of what she valued. She felt that the life of a scholar was among the most important and prestigious. She was a lawyer by training. But she had-- as most, I think, Chinese families did-- a deep and abiding respect for academic achievements. And so it was pretty clear, from the kinds of things that she talked about and the values that she held, that developing new knowledge was really important to her and ultimately to all of the children.

INTERVIEWER: So at that point in high school when you had to really start seriously thinking about the next steps-- going to college, what you might study-- tell me about that decision process. You ultimately went to Yale. And then talk a bit about your experience there.

LO: Well, I was a little confused about what I wanted to do. My sister went to MIT as an undergraduate. My brother went to Caltech. And so when I talked with my mother about where I ought to go for college, she said, well, maybe you ought to think a little bit more broadly about the kind of things that you're interested in.

And so rather than pursuing a somewhat more technical career path, I thought that maybe applying to a general liberal arts college would be a good idea. And I was thinking at that time that I might want to do a combination of mathematics and biology. I did a science project as a senior. I was a Westinghouse Finalist. Intel, I guess, now is what they call it. And I was very much steeped in molecular biology at the time.

And so Yale seemed to have a good compromise in very strong humanities, but also very good science programs. So I ultimately decided that that would be, really, the best compromise. I visited the school, and I was really enthralled with the campus. New Haven wasn't so great. But Yale, itself, was a wonderful physical space for students. And so it was a pretty easy decision, after I had gone through and looked at all the various different possibilities.

INTERVIEWER: You mentioned the Westinghouse Competition. It's amazing how many of our interviewees have a story about Westinghouse and participating in that.

LO: Well, it's a wonderful activity, and obviously not for everybody, but at Bronx Science, most of the students that I interacted with really got into it. And we learned so much from it. I still remember, to this day, every aspect of the experiments that I conducted on the infective pathway of bacteriophage T4.

And I actually corresponded with an MIT faculty, who, at the time, I didn't know. But Jonathan King actually had some strains of bacteriophage that I was interested in and was very generous in sharing it with me. So it was a wonderful experience in getting me to understand how research is conducted, and, really, what the academic style of interactions might be.

INTERVIEWER: So you chose Yale. You decided that that was the place for you. Tell me a little bit about your time there, how your academic and career interests developed, and just sort of what the experience was like.

LO: Well, I had a great time at Yale. It was a really remarkable experience in a number of different ways. When I arrived, I had thought that I was going to be doing math, biology, maybe applied sciences of some sort. But I ended up taking an introductory economics course that was completely different from anything that I had seen before. There was a substantial amount of mathematics involved. But yet the ultimate applications were really quite relevant to day to day experience. And that's quite different from math or physics, particularly at the undergraduate level. So I got very excited about that.

The other thing that I found remarkable about Yale was that, really, for the first time since I started getting interested seriously in academics-- for the first time, I actually met people at Yale that I considered to be really smart, but who had no abilities to do mathematics. In high school, certainly at Bronx Science, you very often equated intelligence with technical abilities. You're good at math, physics, biology--- you were smart.

At Yale, I ran into a number of individuals that were extremely intelligent but were simply not numerate. Their form of intelligence I found really different and fascinating. And that is sort of the beginnings of my interest in economics. I realized that mathematics was not the only way of understanding interactions in a very deep way, and that yet you could actually put the two together in some interesting fashion to come up with some new insights.

INTERVIEWER: So was it sort of an immediate click? You mentioned the Intro to Economics class.

LO: No, it wasn't. I was very confused for a long time. What ultimately decided it for me was a teacher, a professor, Sharon Oster, who taught a fantastic intermediate microeconomics class. She was spellbinding. She provided intuition, developed some very rigorous mathematical models, and made it all relevant and really interesting. So I found her to be an enormously inspiring teacher. And from the moment I took her course, I took every other course she ever taught, and ultimately asked her to be my undergraduate advisor. And I was a research assistant for her, and ultimately wrote my senior thesis with her and some other faculty at Yale. It was a tremendous experience. And so I think that's really what ultimately made me focus on economics as the field that I went into.

INTERVIEWER: Some of those early ideas you've talked about, the relationship or the tension between mathematical models and human behavior, are still present in a lot of what you are interested in, which we'll talk about later. But that's an interesting kind of continuity.

LO: Well, it is. And I think it's also a part of my interests even back in high school, with The Worldly Philosophers, but also from the science fiction perspective. I, as a high school student, read Isaac Asimov's Foundation Trilogy. And the notion of using mathematics to predict the course of human evolution, I found completely captivating. And I didn't know it at the time, but economics was probably the closest field to this fictitious psychohistory that Asimov talks about. And so I suspect that that had something to do with it as well. But all of these pieces were really amorphous to me at the time. And only with the benefit of hindsight does some of it seem to make sense.

INTERVIEWER: It's funny. I just randomly, for some reason, over the weekend had picked up the first Foundation, the first of the trilogy. I had read it years ago. Were you a science fiction fan? Was that something that kind of drove your interest in science?

LO: I was. I read a lot of things in that genre as a high school student. But mostly Arthur C. Clarke. He was one of my favorite writers, Robert Heinlein. But Isaac Asimov was a favorite, not so much because of his writing style. I actually found Asimov's writing style not nearly as pleasurable as Arthur C. Clarke. But the range of ideas that Asimov had in his books were just astonishing, from I, Robot to the Foundation to all of the other short stories that he wrote, his field of vision was really tremendous.

And so that got me very much excited about the possibilities of science. And many of his ideas of science fiction have actually become science fact over the last couple of decades.

INTERVIEWER: So like so many people at MIT, you had an early interest in science fiction and science. But you chose to really move in kind of a different direction in college. Was it difficult to say goodbye to science? It's not saying goodbye. Maybe that's the wrong term.

LO: Well, that's just it. You see, I actually didn't think I was saying goodbye to science, although in many respects, I think I should have been. And we can discuss that later. But my thinking was that economics could be as rigorous a science as the physical and biological sciences.

And I remember having many dinner conversations with my elder siblings, who, of course, were scientists, and who, of course, as elder siblings do, spent a fair bit of their time torturing me, asking me to justify my existence. And so I've actually spent a fair bit of time thinking about whether or not economics is or is not a science.

I, of course, think it is. And when I was in college, my interest in mathematical economics was probably motivated by that drive. The ability to use formal mathematical and statistical models to make precise statements about economic phenomenon was what I thought I was doing and studying in college. And it wasn't until grad school that I had a bit of a rude awakening to that effect.

INTERVIEWER: We'll move on to grad school in just a moment. I just thought I would ask, were there other very formative or important experiences in college that pushed you in a particular direction or helped form your ideas?

LO: A couple. One was another professor, Herbert Scarf, who taught a graduate course in economics, microeconomics, and economic theory. And game theorists, Pradeep Dubey and Martin Shubik, I took their courses as well. And during those courses, it became clear to me that using formal models to study human behavior was both a bit of a treacherous exercise-- there is a lot of behavior that doesn't fit neatly into these models.

But at the same time, those were the heydays of general equilibrium analysis. And tremendous progress was being made in developing mathematical theorems that would demonstrate the existence and uniqueness of economic equilibrium.

So it was a heady time for the literature. And as an undergraduate, I got exposed to some of it through the faculty. Yale's economics program is really tremendous in that they do expose the undergraduate students to graduate level courses if and when they're ready and they're interested.

And because they also allow for opportunities to write an undergraduate thesis, you actually can engage in research even at that level. So my senior thesis was on game theory, and ultimately, I actually got it published. So that was a really fascinating process that I enjoyed and it gave me a taste for the academic and a sense that there's a lot that could be done with relatively simple mathematical tools.

INTERVIEWER: You decided to pursue graduate studies. You went onto Harvard. You went immediately from undergrad on? Or did you--

LO: I did. And in retrospect, that might not have been the best thing to do. But part of it was financially driven. Because we came from a single-parent household and we didn't have very much in the way of financial resources, I actually graduated from Yale a year early. And when I was thinking about what to do, I was actually choosing between law school and graduate school. Because I was also interested in applications and seeing how these ideas could actually affect reality in practice.

But then I did a very simple economic analysis. Law school was three years, and the tuition was however many tens of thousands of dollars. And graduate school was, for all intents and purposes, free. Not only was it free, I found that they actually paid you to go to graduate school! They gave you a stipend. And so, to me, the answer was clear. I have got to get a PhD. That, and also the fact that my brother and sister were PhDs, as I said, provided some motivation for me to achieve that level of success from an academic perspective.

So I think that ultimately I decided that going to grad school was the right decision. And given that my undergraduate advisor, Sharon Oster herself, received her PhD at Harvard and spoke very highly of the program, that was a very easy decision for me.

Actually, MIT and Harvard were the two choices that I had considered. At the time, I really didn't have much of an interest in finance. I didn't know what finance was about. And so, really, for my interest in mathematical economics, I thought that Harvard would be a better choice.

INTERVIEWER: Did you know Boston at all? Had you been here? I was actually going to ask if you had been to MIT? You had a sibling who had attended MIT.

LO: I have very fond memories of MIT because when I was in junior high school, my sister was an undergraduate here. And so we would come up every fall, and bring her up here by car. And I would stay here for a couple of days to make sure she got settled. And while here, I spent an enormous amount of time in the Student Center playing, at the time, pinball machines. I don't know if they have any pinball machines here now. But I spent a lot of time there and roaming the campus. So I loved it. And I developed early on an affection for MIT.

INTERVIEWER: But you went to Harvard, nevertheless. So tell me a little bit about your graduate school years. Again, I'm very interested in significant professors, mentors.

LO: Harvard was a bit of a rude awakening in a couple of respects. Probably the most significant was that the faculty member that I was hoping to work with ultimately ended up being on leave the year that I arrived, in 1980. So I ended up taking classes in micro, macro, and econometrics like all the other first year students.

And I was hoping that the material that I learned as an undergraduate would be expanded upon in graduate school. I knew that the models that we developed in undergraduate classes were relatively limited, and that with more mathematics and more understanding of economic concepts we could develop more realistic models. So I was actually quite disappointed when, after the first semester of my first year, I realized the models that we developed were pretty much identical to what I had done at Yale, and that there wasn't anything more. It was a bit frustrating for me.

In addition, at the time the Harvard economics program had some difficulties. They were going through a transition where some of their faculty were on leave. And the faculty that were there at that time were not really supposed to be teaching in a first year core. So the core was somewhat uneven. And a number of us became quite frustrated with that experience.

And so by the end of the first semester, I had actually filled out my application for law school. I thought I had made a bad mistake. And it wasn't until I happened to take a course in the spring semester taught by Bob Merton in finance here at MIT that changed my mind completely about graduate school. That was really the most formative experience for me, realizing that you can actually apply very sophisticated mathematics, but in very practical settings.

And that was what was missing from general equilibrium theory and game theory. I didn't feel that the mathematics really brought us to any closer understanding for practical kinds of situations, whereas finance seemed exactly what I was looking for. So after that point, I realized I wanted to do finance.

INTERVIEWER: So for the truly ignorant, such as myself, what do you mean when you say finance? I think people tend to gloss economics, finance, even business into one bucket. Talk about exactly what was appealing and what it was.

LO: Sure. In fact, they're very closely related, not surprisingly. Finance started out as a branch of economics. But it has gotten to the point where it has become so much more sophisticated in terms of the models and methods that are applied that it has taken on a life of its own. So in a nutshell, finance is simply applying economic and mathematical principles to the study of money, investments, in a world of uncertainty.

Uncertainty is really the key, because, for the most part, economics is actually pretty well understood in the case of perfect certainty. If there is no randomness in the world, we actually understand a lot about supply and demand and how individuals engage in various kinds of economic decisions. The sole aspect of the world that makes finance interesting and nontrivial is the fact that we don't know what's going to happen tomorrow. And uncertainty really underlies all of what financial models are about.

So in trying to model the dynamics of financial markets, banks, asset management companies, hedge funds, investment decisions, corporate financing challenges, all of those are problems that ultimately involve economics, but financial economics. And because the tools of finance have evolved so rapidly and so differently from other areas of economics, it has really become almost a separate field unto itself. In fact, most finance research is done in business schools. Many economics departments, including Harvard, have now hired a number of very talented first rate financial economists. But for the most part, the majority of the financial economists are actually in business schools not economics departments.

INTERVIEWER: So you had this very, very significant experience taking this course with Bob Merton. Talk about how that influenced your path in grad school.

LO: Well, it really changed it completely. Up until then, my focus was really on mathematical economics and game theory. But once I took Bob Merton's course on introductory finance, I realized that there is so much more applications of genuinely substantive mathematics to problems that cannot be solved in any other way, and that yet can bring tremendous insight that ultimately affects practice. That's not something that game theory or general equilibrium theory has really been able to do.

So once I took Bob Merton's course in finance, I basically took every other finance course offered at the time at the MIT Sloan School. Fortunately, at the time, and even to this day, Harvard and MIT have a very collegial relationship, where students from one university can cross- register, and almost seamlessly take classes in the other university. So it worked out beautifully, where I was able to take all of my courses in finance at MIT. And when it came time for me to take my qualifying exams at Harvard, I petitioned to create a special field which was finance. At the time, they didn't have a field called financial economics. So I had to petition, and, fortunately, was able to get one of the economics faculty at MIT to examine me in that discipline.

INTERVIEWER: So the research you were interested in taking on as a grad student, just talk about it for a bit in light of this new interest that developed in finance.

LO: One of the things that I started out with thinking about in economics was investments. I was fortunate to have as one of my main advisers professor Andy Abel, who currently is at Wharton. But at the time, he was a junior faculty at Harvard. And Andy had been working on investment theory, the idea of how capital in the United States and elsewhere get created from various kinds of economic considerations. When you buy a machine, and you invest in it, you plan to use it for many years. What makes you decide to buy a machine, versus renting or postponing?

This kind of investment theory fascinated me. But I couldn't understand how the kind of investment in machines translated to investments in the stock market. I knew that the two had to be related. We both use the word investment in those contexts. And yet, the kind of models that were developed seemed really different. My finance courses seemed very different from my macroeconomics courses in that respect.

And so I spent a good part of my graduate days trying to reconcile the two. I remember talking with Fischer Black during his office hours and asking him how could it be that, as an economist, we use the word investment to mean purchasing physical capital, whereas in finance, when we think about investment, we talk about purchasing shares of a company? Those two activities ought to be related in some very fundamental way, shouldn't they? And Fischer Black said, yes, they should. And I said, well, but there's nobody who's working on that. How do we reconcile the two? Doesn't this bother you? And he replied that when he runs into contradictions and inconsistencies, that actually delights him. Because he realizes that means that there is work to be done!

And so that was a big insight for me, that I shouldn't get frustrated. I should actually be thankful that there was a thesis topic that was emerging. And ultimately, that's what I spent my years working on in my thesis, integrating real and financial investments in a mathematically consistent framework.

INTERVIEWER: One thing that I meant to ask you before-- I don't want to get sidetracked. But I'm just curious. Maybe you can sort of put it in the context of the work that you're taking on. What is general equilibrium theory? And what are what you saw as its shortcomings.

LO: General equilibrium theory is a fascinating idea that was developed centuries ago by French mathematician, Leon Walras, and others. And the idea sounds so simple. But actually, it's quite complicated to work out. The idea behind general equilibrium is that when you look at an economy, you have to focus on all the various different markets that exist, each one corresponding to a different commodity or good. And within each market, you've got individuals that demand a good and individuals that supply the good. And in each market, ultimately the intersection of supply and demand determines the so-called equilibrium price for that market.

Well, the fact is that all of these markets are going on at the same time. And so instead of looking at what happens in one market, in order to truly understand how an economy changes over time, you actually have to ask the question, how do all the markets equilibrate together?

General equilibrium does exactly that. It says that, given a collection of individuals that all consume certain commodities, and given a set of businesspeople that produce those commodities, there have to be a set of prices for all the goods that are traded in that economy so as to equate all the supply with all the demand across all the markets.

Now that seems like a really tall order, to expect that this kind of an equilibrium would occur across all of these different venues and settings. And the idea behind general equilibrium is to determine the conditions under which such a general equilibrium across all these markets could actually occur. Some beautiful mathematics are involved in this. And not only are there interesting mathematics about the existence of equilibrium, there's additional mathematics that say something about whether the equilibrium is unique, and what happens when you're outside of an equilibrium, and how you reach an equilibrium, how you move from one to the other. So it's an endlessly fascinating series of questions that actually relies on some very deep mathematics to understand.

But the problem with these so-called theories is that they have become so general, they are so abstract, that they've become divorced from reality. Because in fact, in practice, you actually don't see general equilibrium occurring. In fact, in many cases, as we've seen over the last few years, markets are often in disarray and in disequilibrium. Prices are moving around all the time, trying to equilibrate.

And unfortunately, the mathematics and the direction of the literature on general equilibrium hasn't really focused as much on the transitions, the dynamics from one to the other, as opposed to what occurs at an equilibrium. And so in that sense, I think finance has become a much more relevant discipline, because it actually has testable implications that have some very, very practical applications.

INTERVIEWER: To return to your graduate work just for a moment, you develop mathematical models to sort of compare investments in stocks, bonds, with goods or machinery, and so on. I'm no mathematician. But can you talk about what kind of relationships you found? And again, if you use your mathematical models it will not mean much to me, I'm afraid.

LO: Sure. Well actually, it's pretty straightforward. The results that I developed in my thesis really focused on what kind of investment policies of a corporation would be necessary in order to support the kind of real business activities that it engaged in.

And the answer is actually pretty simple, and hearkens back to some research that was done by MIT economist, Franco Modigliani, years ago. In a market where there are no frictions, there's no cost to engaging in issuing stock or issuing bonds-- in a frictionless market and a market with no taxes, the answer is that the real economy and the financial economy are pretty much separable. It doesn't matter how you would finance a purchase of a new machine-- whether you use debt financing or equity financing-- because in a costless world where markets are perfect all the time, you can shift from one to the other pretty easily. And therefore, the financial side is almost an afterthought.

But the problem is that as soon as you introduce market frictions, that changes completely. And really, it's the frictions that make things interesting. You have to understand where the frictions are coming from and how they relate to the different sources of financing. And with market frictions, with taxes, it turns out that there actually is an optimal combination of equity and debt financing that will support the kind of growth that a real business activity entails.

And so working out the mathematics of it is really what I did in my thesis. And it was done in a dynamic context, so it was not just a static, one-shot kind of a perspective. It was really couched in the framework of a company that was engaged in multiple projects over the infinite future. And so that really gave me a deeper understanding for how to integrate the real and financial sides of the economy, and gave me an appreciation for why it is that frictions really are at the core of what we do in economics.

So much of economic theory is the frictionless case. And those are important cases, because you have to understand the frictionless case before you can start seeing how frictions matter. But we often forget that frictions do matter-- because we get so enthralled with a frictionless case, given that the mathematics are so beautiful-- that we don't go to the next step, which is to say, let's make it messy again by building in these frictions. And frankly, that's what I've been working on ever since.

INTERVIEWER: You mentioned Robert Merton. Were there other significant mentors, influences during your graduate years that we should talk about? I think you've actually mentioned a couple of others.

LO: Absolutely. Jerry Hausman was a critical figure in my intellectual development. Jerry is an economist at MIT, an econometrician. And it turned out that I got to know him because I took an econometrics course with him at Harvard. He was on sabbatical from MIT, and he decided to spend the year at Harvard. And so he taught a graduate econometrics course that I took and I did well in. Well, enough that he hired me as a research assistant that summer, and then hired me to TA that course the following year. And I really enjoyed it and enjoyed working with him. And ultimately, he became one of my principal thesis advisors.

He was the one who gave me the idea that you could actually use rigorous econometric techniques to apply financial concepts to the data and learn a great deal about how these theories actually worked in practice. And so the field that I ultimately spent most of my early career on, financial econometrics, grew out of my interactions with Jerry, and countless conversations, and free lunches and dinners that Jerry treated me to very generously, during the time that I was his student.

INTERVIEWER: We tend to think of graduate students, particularly at places like Harvard and MIT, as being involved within this all-consuming research quest for knowledge. Were there other things going on in your life that were really important to you or significant? Or did you find yourself getting really sucked into the work?

LO: Well, no doubt, graduate school was very intense. But it was a fun intense, in the sense that it was, for the first time, an experience where I was surrounded by people that were all interested in the very same relatively narrow field that I was. So that was a new experience and a very enjoyable one.

At the same time, I was also working as a research assistant and as a tutor, because financially, it was a bit challenging for my family. And so I learned about the real economic life of making money for supporting myself.

I was also dating a girl who ultimately I married. My wife, who, at the time, was an undergraduate at Yale still. And so we had a long distance relationship for my days at Harvard. And I remember spending enormous amounts of money on phone bills. And it was really then that I got into the habit of staying up late at night, because after 11 o'clock, the rates went down. And even so, had we been able to avoid these long night phone calls, we probably could have purchased two cars by the end of my graduate school days. So that was probably the most significant other activity that I was focused on during that time.

INTERVIEWER: So you're a newly minted PhD. What's next?

LO: Well, when I went on the job market, my wife--- my girlfriend at the time--- was a graduate student in a PhD program in finance at the Wharton School at the University of Pennsylvania. So I was fortunate enough to be interviewed by them. And they flew me out to give a job talk, and made me an offer the next day. And I accepted the next day after. So by the middle of January I was actually done with recruiting because my girlfriend was there. And so it was pretty easy.

Also, the Wharton School is renowned in the area of finance, and it was a bit of a new thing at the time for an economist to be hired by a business school. At the time, most business school faculty were hired from business school PhD programs. And there was some crossover, but not a lot, and certainly not a lot of crossover in finance. Finance was really a field unto itself at the time: that was really more a business school activity. And economics departments were only really beginning to start thinking about offering classes in finance, never mind concentrations in that field.

So when Wharton made an offer, to me, it was an ideal situation. My girlfriend was there. It was a bona fide and very well respected finance department. And my only fear was whether or not I was going to be able to measure up to a finance department where I was an economist, an outsider.

INTERVIEWER: Did you ever think twice about pursuing an academic career, as opposed to Wall Street or other options?

LO: Well, I did a little consulting when I was a grad student because the summer between college and grad school I was a summer intern at a company called Data Resources. It's a software company started up by some Harvard faculty--- Otto Eckstein, Dale Jorgensen, and others--- and at DRI, I actually was working on developing software for engaging in a variety of economic analysis. Maximum entropy spectral analysis was my project that summer.

And so I did a bit of consulting for DRI during my years as a grad student. So I thought a little bit about going into industry. But because I was so fascinated by the kind of questions that came up in my thesis and I wanted to continue on, and, I think, because the family upbringing that I had clearly valued the academic lifestyle-- my brother and sister were both academics at the time-- it really was clear to me that I wanted to follow an academic path.

INTERVIEWER: Let's talk a little bit about your years at Wharton. What were your research interests? What kinds of things were you engaged in? And also talk a bit about teaching as a young faculty member.

LO: It was a very interesting mix of experiences that I had, even in my first year at Wharton. When I started in Wharton in 1984, I was 24 years old, which is relatively young for a business school faculty member. In fact, I remember very clearly my very first day of class, I was clearly younger than most of the students in that introductory finance class.

There must have been 100 people in the room. Wharton has quite a large program, and they have big classes. And before I actually began lecturing, literally the very first day of class, a student raised his hand. And so not knowing any better, I called on him and the student said, Professor Lo, before you begin, we just have three questions. And I should have known right away, when they use the royal we, this could not have a good ending.

He said, first, can you tell us whether you have ever taught this course before? Second, can you tell us what kind of consulting experience you have in this area? And third, can you tell us how old you are?

And not knowing any better, I answered the questions. I said, no, this is my first year. I've never taught this course before. I have no consulting experience, really, to speak of. And I'm 24,

at which point literally half the class got up and walked out of the room, because they decided that they wanted to go to another section with more experienced faculty. And I guess I can't really blame them. They're paying a lot of money for their tuition.

But that was a sobering experience. And it only went downhill from there. So I was baptized in fire, in terms of MBA teaching. And so that was a very important experience, a formative experience for me.

But on the bright side, the experience at Wharton was tremendously productive for me and the other junior faculty, because it turned out that in that year Wharton hired nine assistant professors just in the finance department, so I was one among nine. And the good thing about it was that because we came in en masse, we became very close very quickly, the nine of us,

socializing with each other after hours, basically hanging out all the time, because as an assistant professor, there's not much else to do anyway. None of us had families at the time. Some of us had girlfriends or wives. But we didn't have any children. So we spent a lot of time together.

As a result, the department had to get used to us more than we had to get used to the department. And that was an incredibly important experience because it allowed us to ask really interesting research questions without the concern that some tenured faculty member would disapprove. Because frankly, the tenured faculty members weren't even around to interact with us, given their priorities and activities.

So we spent a lot of time interacting with each other, challenging each other, talking with each other about ideas, and ultimately one of the most fruitful collaborations that I had in my career started in that year with Craig MacKinlay, who was another assistant professor from the University of Chicago.

INTERVIEWER: Presumably, your experience with the students got better from that low point?

LO: It did get better. And as I said, I learned very quickly that MBA students are very demanding, and with good cause. They are spending a lot of money on their tuition, and they obviously have to start thinking about paying it back in many cases with student loans afterwards. It became clear to me that relevance was really key. But, more importantly, that there was a certain impatience among MBA students with respect to abstract theories that may or may not lead to some very specific practical implications.

And in time I learned to appreciate that perspective, and begin to take it more seriously myself. Not to say that academic theories are devoid of practical consideration. But there is a very important divide between theory and practice. And I don't think that academics necessarily appreciate that as much as perhaps they might or that they would if they, themselves, were placed in kind of a practical environment.

INTERVIEWER: How did your research interests evolve as a young faculty member?

LO: That was a wonderful thing about Wharton: it's that we didn't really have any particular directions that we were expected to take as junior faculty. And so we were pretty much free to think about whatever it is that appealed to us.

And my thoughts as a first year faculty member were really in the direction of this notion of market efficiency, and the ability for the real and financial sides of the economy to engage in pretty much separate kinds of directions.

As an econometrics student in Jerry Hausman's econometrics course, one of the things that I looked into was the ability of testing the random walk hypothesis using a particular statistical procedure. Really, it was just an exercise at the time to see whether or not one could use fancier statistical methods to test the age-old idea of whether or not you could use past stock market prices to predict future stock market prices.

One of the foundations of efficient markets hypothesis is the notion that all the information about the future of a company is actually contained in its current price. And if that's true, that means you can't use past price realizations to forecast future directions of the market.

And as a student in Jerry Hausman's econometrics course, I developed an idea for using a statistical test to capture that hypothesis. So when I got to Wharton, I started talking with Craig MacKinlay. He and I had lunch pretty much every day. And over lunch I would tell him about these ideas. And he would say, well, we can actually take it to the data. In my thesis, I spend a lot of time testing various ideas,

but I hadn't really done much with stock market data at the time. So he and I began to work on this. And shortly thereafter, we came up with a rather startling conclusion. Using the tests that we developed and applied to the data, we came to the conclusion that US stock market prices actually don't satisfy this random walk hypothesis. Stock prices aren't actually purely random.

And at first, we thought that we had made a programming error. But in fact, after several repeated attempts to explain away these findings, we came to the conclusion that this is exactly what the data had to say.

And so we tried to get the paper published, and when we presented it at a conference we were completely trashed by our much more senior and well-respected discussant who simply didn't believe the results. His view was that markets could not possibly be that inefficient, and that somehow you must have made a programming error, which in our business, is worse than calling your mother a four-letter name.

So we got very excited and agitated, and went back to our computers and reprogrammed, and looked at the results. And ultimately, we were vindicated in the sense that this really was a feature of the data and from that point on, for about a period of 10 years, Craig and I wrote a number of papers to try to explain this anomaly, and ultimately published a book that collected all of our papers to try to understand this phenomenon.