portfolios

Power of Haas Ideas

Modeling Portfolios

Haas Prof. Nicolae B. Gârleanu helps explain the apparent irrationality of financial markets, solving problems that have long confounded economists—and helping investors build optimal investment portfolios.

Economists have long understood that financial markets aren’t perfect. The prices of stocks, bonds, and other assets can vary tremendously from where classical theory says they should be. The reasons stem largely from the overwhelming complexity of the real world of finance, where information is imperfect, human beings are sometimes irrational, and situations can change between the time an investment idea is hatched and when it’s acted on.

Haas Finance Professor Nicolae B. Gârleanu has built a growing reputation in economics and collected a shelf full of awards for groundbreaking work exploring the complications that make prices so unpredictable and financial markets hard to fathom. A mathematician by training, Gârleanu inhabits the rarefied world where finance and advanced mathematics intersect. The technical analysis that fills his work can sometimes seem as esoteric as theoretical physics. But, his peers say, Gârleanu’s underlying ideas are bold, important, and often startlingly original. And his technical innovations offer fresh approaches to problems that have long confounded economists, such as how to construct the best possible investment portfolio and why markets are subject to booms and busts.

Gârleanu, the Paul H. Stephens Chair in Applied Investment Analysis, is known for building models that take into account a wide range of factors that influence asset prices and investment results. For example, in a 2005 paper written with New York University economist Lasse Heje Pedersen, Gârleanu showed how the aversion of market participants to risk distorts stock option prices, helping explain puzzling irregularities.

Gârleanu’s recent work on portfolio choice is drawing attention in both the academic and investment worlds. In a 2016 article coauthored with Pedersen, “Dynamic Portfolio Choice with Frictions,” he develops an original mathematical framework for looking at the problem of building an optimal investment portfolio, given the costs of trading and the flood of information financial professionals are deluged with. The article, published in the Journal of Economic Theory, examines how investment managers can balance the costs of buying and selling assets with the benefits of holding those assets in a world of constantly changing information and prices. “This work is important for understanding real, fundamental problems,” Haas Finance Professor Terrence Hendershott says. “Asset managers have read it and thought about it carefully.”

The key insight in this work is the importance of persistent investment results. Say a fund manager has an idea that a particular stock will produce superior returns. The question is whether those excess returns will last long enough to offset the costs of acquiring that stock. The longer those returns are expected to continue, the more aggressively the fund manager can build a position. Gârleanu and Pedersen use an entirely new mathematical technique, much simpler and easier to use than previous portfolio-analysis methods, to show that investors should ignore the flash in the pan and keep their eyes on longer-term results. Stanford University Finance Professor Darrell Duffie, who has worked with Gârleanu, describes this framework as revolutionary: “He completely departed from previous paradigms. His model is completely novel and he achieved beautifully elegant results.”

This model may apply in fields as varied as monetary policy, politics, and business strategy, Gârleanu believes. He cites the hypothetical example of a manufacturing company considering introducing a new product based on what’s hot on social media. “How do they react to new things trending on Facebook?” he asks. “If they think the trend will last for a month, they won’t build a new factory. But if it will last for two years, they might build a factory.”

Gârleanu grew up in Bucharest, Romania, and came to the United States in the mid-1990s to attend the University of Pennsylvania. A friend persuaded him to take an advanced finance class at the university’s Wharton School of Business and Gârleanu was hooked. “Finance had a way of thinking about the issues that was appealing. The subject matter is young and vibrant, and you can actually reach the envelope of knowledge quickly and contribute to it,” he explains. Gârleanu made the leap from mathematics, collecting his PhD in finance at Stanford and coming to Haas in 2007. He lives in Berkeley with his wife and three children. —Sam Zuckerman

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