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Ideas Made to Matter
Finance
By
Kara Baskin
As markets churn, here are some sound principles to ground your investing decisions from MIT Sloan finance experts and economists.
Predicting the stock market is never easy — even less so when inflation persists, conflicts escalate, currencies fall, and interest rates rise.
MIT faculty have advice for weathering turbulence. Ahead, here are some sound principles to ground your investing decisions as markets churn.
Mutual funds are a popular and effective way to diversify risk, with research showing that they comprise around 58% of retirement savings. That said, these funds tend to issue hard-to-read disclosures and maintain complicated fee structures. MIT Sloan assistant professor of accountingand co-researchers explored how mutual funds’ convoluted disclosures contribute to investor frustration — and, sometimes, underperformance.
The average American invests significantly more of their money in the stock market than they did in the last few decades. This is a trend accelerated by the popularity of target date funds, according to research fromMIT Sloan professor of finance and co-director of the MIT Golub Center for Finance and Policy. These crock pots of the investment world optimize risk depending on an investor’s age and could have quantitatively large and even soothing effects on stock prices, he said.
Not everyone’s a fan, including Nobel Prize-winnerPhD ’70, a distinguished professor of finance at MIT Sloan. He decried target date funds at an April 2022 MIT Sloan event.
“This is an investment strategy that never updates. … It never uses new information about you or the markets,” he said. “If that were good enough to get you to a good retirement in 10, 20, 30, or 40 years, those of us … in the financial service business really should look for another profession.”
Less predictable are options markets, where novice investors can lose big.
“Options can be much riskier than equities for unsophisticated investors,” said a professor of accounting and finance at MIT Sloan. “It requires only a small amount of money to buy an option. And if things go well, it can pay off huge, but in a lot of cases there’s no payoff and investors lose 100 percent of their investment.” A new paper by So and co-authors found that retail investors make “a trio of wealth-depleting mistakes” when investing in options.
Research co-authored by MIT Sloan professorfound the Federal Reserve’s decision to buy corporate debt and other risky assets has the potential to create more market volatility, not less.
When making decisions about how to create and preserve normalcy in tumultuous times, such as the 2008 – 2009 financial crisis and the recent pandemic, the central bank “is at risk of putting too much weight on the markets,” the report found.
The authors developed a mathematical model that shows how large strategic investors sell a small part of their risky assets in order to “persuade” the central bank to intervene — thereby pushing market prices up.
The model found that the stronger the anticipated central bank intervention, the more investors artificially depressed asset prices to get the desired reaction: a bump in the stock price and a higher profit.
World events have shaken this market and upended interest rates, but some sectors stand to gain, said experts at the most recent MIT Sloan Investment Conference. Multifamily housing, life science spaces, retail (not office) space, and student housing are safe bets, said James Chung, MBA ’00, chief investment officer of the ROC debt strategies fund at Bridge Investment Group Partners.
Also drawing outsized attention are financial technology innovations from investment companies. For example, robo-advisers from organizations such as Betterment, Wealthfront, and Ellevest are winning customers with inexpensive, algorithm-driven investing advice.
Investing in fintech itself is also a good idea: “Tech in general is just extremely hot,” saida visiting associate professor of finance and managing partner at venture capital firm Tectonic Ventures.
Not a product but a philosophy, ESG investing — for environmental, social, and governance — is a niche no more. However, it’s important to ask key questions before investing, saida senior lecturer in finance at MIT Sloan. They include: Do ESG index funds vote in alignment with shareholder preferences? Is a company delivering on the social and governance vectors of ESG, in addition to environmental concerns? And do investments address pandemic- and climate-related inequality?
Sustainable investing will truly take off once the old guard buys in. What might sweeten the pot? As far as influential and perhaps intergenerational companies and foundations are concerned, it’s important to ensure that key investor goals are aligned, outdated mental models are refreshed, and impact is ranked and measured in a standardized way, saiddirector of the MIT Sloan Sustainability Initiative, at a 2021 MIT Impact Investing series talk.
Jay and colleagues are working toward solutions for each of these three challenges, including Owning Impact, an executive course that helps family foundations build socially aware investing strategies; the Climate Pathways Project, which helps top decision-makers adopt evidence-based climate policy; and the Aggregate Confusion Project, which helps companies assess sustainability performance.
DeFi is touted as an efficient alternative to traditional banking, but researchers say regulation is overdue. Some concerns:
DeFi isn’t an even playing field. Financial markets are inherently prone to economies of scale and scope, as well as large network externalities, MIT Sloan finance professorsaid. These forces create pressure for concentration even if there is free market entry.
It’s difficult to collect taxes. Transactions made using digital currencies are taxable, but reporting them isn’t easy given that DeFi is predominantly built on permissionless and pseudonymous blockchains.
Governance issues plague the sector. Unlike traditional finance, DeFi governance takes place via decentralized autonomous organizations, which face the same governance challenges that have plagued cryptocurrencies. Global regulatory coordination could be stronger too, Schoar said.
Speaking of emerging data sources, it’s never been easier for investors to capture exorbitant amounts of data to analyze financial statements or interpret asset prices using algorithms. And traders often use big data when they engage in statistical high-frequency trading.
But how does statistical trading affect the markets? To find out, an assistant professor of finance at MIT Sloan, and co-author Laura Veldkamp, a professor of finance at Columbia Business School, developed a model that incorporated both statistical trading and fundamental trading — whereby traders analyze a company’s financial statements to forecast profitability.
The authors’ research showed that technological growth — defined as the improvement in the ability of a firm or traders to process data using algorithms — did indeed cause a shift to statistical trading.
In the long run, the model indicated, both fundamental and statistical trades will keep growing, and price efficiency will keep improving.
Lessons from the 1918 influenza pandemic and the 2008 financial crisis are instructive in navigating today’s murky waters. No matter what, a diversified portfolio and calm mien are always key, said professor of finance at MIT Sloan, in a 2020 webinar.
“In the medium and longer run, there is going to be a recovery, so you need to examine your goals [and] your particular constraints and resources, and do not panic,” he said.
Read next: How to invest in a volatile market
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