How to Invest When the Market Feels Scary

When economist Andrew Lo, 53, was working on his Ph.D. in the mid-1980s, he had little reason to doubt the theory that stock prices can't be predicted. Then he started on a paper that he thought would show that the market's weekly ups and downs were random.

Things didn't go right. More volatile periods and less volatile periods were strung together.

"We discovered, to our shock and amazement, that the theory failed," recalls Lo, sitting in his tidy MIT office overlooking the Charles River in Cambridge, Mass. He and collaborator Craig MacKinlay spent a decade confirming and trying to explain their results. The answer involved a bit of economics, a bit of psychology, and a bit of evolutionary biology.

Lo, who has advised the government on how to avoid another financial crisis, calls his competing theory the "adaptive-markets hypothesis." He says markets are efficient at processing information into prices most of the time. But traders aren't computers: At certain moments, especially in a crisis, investors respond to physiological cues we developed when threatened in the wild by, say, being eaten or speared.

"We're a biological species," Lo says. "We're subject to the same kinds of dynamics as fish in the ocean and springbok on the plains of the African savanna."

Like indexers, Lo doesn't think picking stocks per se is worthwhile. From there, however, he goes off in a totally different direction. He thinks our biological hardwiring causes other aspects of the market, like investors' appetite for risk, to follow patterns.

While you are accustomed to hearing that you must ride out the market's gut-wrenching ups and downs, Lo believes this is not only unnecessary but often counterproductive. Just as trying an extreme diet can backfire with late-night junk-food binges, white-knuckling through a crash won't work if you eventually cry uncle and cash out.

"You're being unrealistic to assume that people will happily see their retirement assets drop by 30% or 40% without doing anything," says Lo. "Let's create a mechanism by which you can react in a safe and orderly manner." He's not just talking theory. In addition to his academic work, Lo co-manages mutual funds. His Natixis ASG Tactical US Market , launched in September, uses mathematical models to monitor changes in volatility.

The aim is to predict when investors' biological imperatives to flee the market are about to kick in. The fund uses futures contracts to shift money in and out of equities exposure, to maximize returns in bull markets and sidestep losses amid panics. Because futures involve borrowed money, stock exposure could range anywhere from zero to 130%.

For investors inclined to indexing, the fund throws up a lot of red flags. It charges a 1.4% expense ratio plus a sales load. The fund doesn't have a long record or hypothetical index results to evaluate. Big investment decisions hinge on complex formulas.

"It's got 8,000 knobs and levers," says adviser Josh Brown, author of the blog The Reformed Broker. While he calls Lo "brilliant," he's skeptical of the fund's staying power. "Getting that complicated works against you," says Brown.

Lo says his fund can get cheaper if assets grow, and argues that for all their seeming simplicity, index funds were once regarded as odd too. Then they worked. "It's the natural evolution of financial products," he says.

The takeaway for you. You can hang back from Lo's unproven fund and still learn from him. Contrary to what efficient-markets purists say, markets go through bubbles and panics. Similar assets may move together in those times, which argues for lots of diversification.

And recognize that your own hard-wiring means you'll be pulled to join the fleeing herd when a bear appears. Even if you think you are risk-tolerant, build an asset allocation with enough safer assets to keep you from feeling threatened. You may not know the next turn of the market, but knowing you can survive it helps.