By Jack Forehand (@practicalquant) —
Artificial Intelligence is going to change the world. It already has in many ways. But its best days are still ahead of it. So many industries, ranging from technology to healthcare to manufacturing, will experience huge benefits from its vast potential.
Investing is one of the areas AI might have the most impact. There are a myriad of uses for AI in investing, and almost all of them will be big positives. It will lead to better investing strategies. It will allow advisors to provide better information to their clients. It will likely lead to continued reduction in fees as firms are able to do things more cost effectively and pass those savings on to clients. It will also likely do many things we can’t even fathom right now.
There is no doubt that Artificial Intelligence will profoundly change the future of investing.
Its potential impact on long-term investor returns is much murkier, however.
But before we get into that, it is helpful to take a look at what Artificial Intelligence is.
Webster’s dictionary defines AI in the following way.
1: a branch of computer science dealing with the simulation of intelligent behavior in computers
2: the capability of a machine to imitate intelligent human behavior
At its core, Artificial Intelligence is about a computer learning to think like a person can. For example, when my firm tests investment strategies currently, we are the ones doing the thinking. We identify strategies and factors that we think impact investment returns and then use both in and out of sample data to test them. But AI changes that. It can take in large volumes of data and decide for itself what works and what doesn’t. It can figure out what to test on its own and how to optimize those tests, and look at millions of unique data points. It can in essence “think” just like a person would while processing vast amounts of data far faster than a person could. Plus, AI can likely perform these functions better than a person because it isn’t subject to biases and emotions.
The major question, though, is will all of that lead to better returns for investors.
There are two fundamental truths to investing. For anything to revolutionize investing, it would need to change at least one of these two truths, if not both.
Those truths are the following:
- No investment strategy works all the time.
- Human beings, when confronted with an investment strategy that is not working, will panic and make poor decisions.
Let’s look at each of these individually.
First, can AI create an investment strategy that works all the time? I think the answer is pretty clearly no. If any investment strategy works consistently, more and more people will follow it. When they do that, its effectiveness will be reduced until the point that it doesn’t work anymore. Computers don’t change that reality. If one computer finds something that generates consistent profits or consistent outperformance over the market, then other computers are likely to find the same thing. As more and more computers, and assets, pile into the strategy, it will stop working. It is very similar to how the process plays out today with humans. If one person discovers something that works, then others are likely to follow, resulting in decreased effectiveness. The process may happen much more quickly with computers, but it nonetheless will play out the same way in the end. That doesn’t mean that AI can’t create investment strategies that can beat the market over time. It very well may be able to identify factors and strategies that work that haven’t been discovered yet. It just means that those strategies won’t be able to do it consistently year after year and will always experience periods where they are not working, just like the strategies we currently have.
Once you accept the fact that no investment strategy will work all the time, even in a world dominated by AI, another investing truth logically follows. That truth is that many investors are going to do the exact wrong thing when that strategy is underperforming or when it is losing money.
To understand why, let me ask you a few simple questions. If I could program a computer to avoid all the mistakes investors make, would you hand 100% control of your investments over to it? Would you let it stay the course when the market is down 40% and you are panicked about your retirement or your children’s college savings? Or if you are an active investor, would you let it stay the course when your strategy trails to market for a period of years while the index fund investors around you are making much more money than you are?
I think the answer to all of those questions is no. In fact, all of those things can be done via computer now, and yet investor behavior continues to be a significant drag on returns. That is why AI cannot fundamentally change investing. Behind every investment strategy is a person whose money is on the line. And the vast majority of people are never going to give up control of that money to a computer. Investors will still panic when they underperform. Investors will still panic when the market goes down. Collectively, because of behavioral biases, investors will still make bad decisions.
None of this is meant to minimize the impact of AI on investing. It will have profound impacts, many of which we likely can’t even comprehend now. But as long as human beings are the ones whose money is on the line, there is also a limit to what that impact will be. That is good news for financial advisors because the comforting and hand holding they provide investors will continue to be valuable, even in a future dominated by technology.
We should all be excited by the potential AI has to change our world for the better. But we should also understand there are limits to that change. Investing is one place where those limits are apparent. As you examine all the improvements AI will bring to the process of investing your money, it is essential to keep that fundamental truth in mind.
Photo: Copyright: krulua / 123RF Stock Photo
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.