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AI vs. Mr. Market

Scott's Column

Lately, I’ve read quite a few articles about the potential of artificial intelligence (AI) to boost the performance of investment portfolios. The pony ridden by AI is off to a bad start in that race.

A June 2nd article in Yahoo Finance points out that the AI Powered Equity ETF (AIEQ) has a 1-year return of -13.92% while the Vanguard Total Stock Market ETF (VTI) is up 2.12%.

A June 10th report by Portfolios Lab shows AIEQ with a 5-year annualized return of 4.10% compared to a return of 10.98% for the SPDR S&P 500 ETF (SPY).

I’m sure there are and will be plenty of examples where AI shines and wins the race over some period against some benchmark. Dart throwing monkeys occasionally beat the market too.

Will AI learn to pick winners consistently? Not likely.

Markets are not subject to immutable laws like the physical universe. There are no constants like the speed of light or the force of gravity.

You can’t discover what makes it tick no matter how smart you are because there is no “it.”

Markets are complex adaptive systems that are the product of decisions made by millions of investors, all with slightly different perspectives, needs, and constraints.

Those perspectives, needs, and constraints change over time in unpredictable ways. They do not exist in a database. They can’t be learned by a computer program, no matter how powerful.

Water always freezes at 32 degrees Fahrenheit but markets can do whatever they want.

And consider the difficulty of trying to outthink Mr. Market. We’ve all seen the graphics that show the consequences of missing the 10 best days in the market, but it’s worth a reminder.

The S&P 500 Index returned 8.81% from 2007 through 2022. If you missed the 10 best days in the market, your return was more than cut in half to 3.29%. If you missed the 20 best days your return was negative. A paltry -.17%. The difference between solid returns and a negative outcome was determined by Mr. Market’s performance on about 0.5% of the trading days.

Also consider that a paper published in 2018 by Professor Hendrik Bessembinder documented that the best-performing 4% of stocks explain the entire net gain for the stock market between 1926 and 2016. The other 96% of stocks collectively matched the performance of one-month Treasury bills and most of those lost money. The target to beat Mr. Market is very small indeed.

AI operates by processing massive amounts of data and “learning” from the data it consumes. It has no independent ability to predict the future. Where would it find data that would allow it to glean the future prices of stocks? Maybe from the collective wisdom of active managers?

Unfortunately, this is not a very rich milieu for discerning market-beating intelligence. Year after year the SPIVA Scorecard teaches us this lesson.

That report shows that on average for the last 20 years (2003-2022) 65% of all large cap domestic equity managers have underperformed the S&P 500 Index for the calendar year. For the most recent 5-year period 87% have underperformed. For the most recent 10 years, 91% have underperformed. What is AI to do with the collective wisdom of this crowd?

Markets are tricky beasts. Their performance is determined by millions of humans around the globe acting independently, which makes them somewhat whimsical. A very few days and a handful of stocks determine their performance over many years. Some of the smartest humans on the planet have yet to discern their secrets, try as they might. Can AI crack the code?

The odds seemed dramatically stacked against AI. AI will certainly have a profound impact on our world and even on the business of investment management. But don’t count on it to out-think the moods and desires of investors.

Active managers, technical market analysts, the nerdiest quants, tactical asset allocators, and crystal ball gazers of all varieties, armed with the latest techno wizardry have beat their heads against the wall trying to outperform the markets. In the long run, almost all have failed.

AI is mind bogglingly powerful and will change our world dramatically over the coming years. Just don’t expect it to win a horse race against Mr. Market over the long term.