11 May 2011

Andrew Lo: What a boss

``If you have no interest in money or don't care about making money, talk to me after lecture and I'll fix that.'' --A. Lo

Andrew Lo, a renowned finance professor, talked about how we could use financial engineering to solve society's three biggest problems (cancer, global warming, and one more that I forgot). His plan is similar to what MIT did to win the Darpa Network Challenge: to incentivize people who give money to solve problems, essentially relying on human greed, which has always been and will continue to be a part of human nature. (Fear, another powerful tool, only works in the short term; if one is constantly afraid of something, then he is not capable of surviving.) Lo gave the following example:

Suppose that, for a pharmacutical, developing a drug for cancer cost \$500M, had a cycle of 10 years, and a 5% success rate. A successful drug would make \$2B a year. If we only invested in one pharm, then they would have a pitiful return. However, if we invested in forty pharms, then our probability of having at least one successful drug is 1-(1-0.05)^40, or 87%, which is much higher than 5%. We would then need \$20B, which we can get from one-tenth of America families if each family contributes \$2,000. We can further incentivize by deducting this amount from the family's tax.

This \$20B we get from taking advantage of people's inherent greedy nature is supplemented by donations from the altruistic, which amounts to \$25M. Of course, this is a very simple model, but if we learn to take advantage of greed and focus it like a giant laserbeam to benefit society, say curing cancer, then we are capable of achieving great things.

Edit: typo in math; 0.87 = 1-(1-0.05)^40, not 1-0.05^40.