AI is excited about jumping cats, How come AI can not solve the US 100 trillion investment management which can not beat the benchmark? The answers I got. The cat is important not the benchmark. AI needs to take small steps. Solving Cancer more important than beating the benchmark. Driverless cars more important focus. We don’t have another financial crisis to ask that question.
Finance is a key milestone for AI. Imagine coming back from vacation and talking to your virtual assistant about your investment portfolio and wondering how she does it, quarter after quarter, year after year. Managing money is the real test for human AI. It has to talk, it has to think, it has to have intuition and it has to make money. Despite the AI Game successes, there is no AI player with such capability today and it’s unclear whether brain emulation under Strong AI is the preferred direction for achieving human AI. This paper uses a historical context to explain why it maybe time to denounce social systems, embrace system thinking, and explore simple ideas like computational linguistics to explore technologies that can teach computers to talk, think, assimilate knowledge and hence also manage money. Such technologies should set up the foundation for Web 4.0.
Finance does not understand the physics of preferential attachment. According to Taleb, the intuitively appealing preferential attachment is incomplete. This is a tragedy for his ‘Black Swan’ because preferential attachment is the other name for ‘Rich Get Richer’. Taleb bases his philosophy of randomness on the non-normal power law behavior which is also another way of looking at ‘Rich Get Richer’ mathematics.
The two Nobel Prizes awarded in Economics in 1990 [1] and 2013 [2] define the boundaries of Modern Portfolio Theory (MPT). Size is the pillar for both the models. The 1990 winners assumed market to be driven by Market Capitalization (MCAP) [3] size, while the 2013 winner explained that factors like ‘Small Size’ [4] can explain portfolio performance better than ‘Big Size’ [5]. This conflict between the two ideas has bifurcated the industry into benchmark investing (MCAP) [6] and everything else not MCAP (Smart Beta) [7]. The fact that benchmark investing and smart beta is expected to be 50% of the USD 100 trillion investment management industry in 2020 [8] makes it imperative to seek a coherent argument and a conflict resolution.
When you make a big claim, you have to be careful. This is the lesson hardest to learn. I am still learning it. My stock market education helped me a lot. The one thing it always taught me was to be ready for a surprise. It happened again today, as markets got Trumped. The idea of frequent outliers is hard to grasp because humans herd. It gives us comfort to herd but that’s the only way the society can function. It has to form clusters and then burst them. The only way for life to continue is by surprises. The role of uncertainty is so critical when it comes to system functioning. This is why sticking your neck out is a dangerous way to live. Nobody can tell you this better than stock market forecasters. The pundit to disrepute journey is very uplifting and humbling. Anyway, a failed forecast is good for system building as it forces us to go back to the drawing board and look into our systems. Hence there is a positive flip side to every surprise.
Standing against the establishment, having a voice and speaking up needs courage. This is what you did. You spoke up against the industry which started the first Mutual Fund in 1775. Bloomberg calls it a revolution, you call it a revolution, Wall Street Journal is calling it differently, but that does not matter. Mutual Funds are in a descent. Stock Pickers might still continue to follow Graham and Dodd approach, but the facts are overwhelming. If an institution can’t beat the index then it is wasting resources.
Though ‘Size’ is the most important factor explaining stock market returns, the possibility of size being a proxy was first mentioned in Banz (1978). Even after forty years of factor investing the industry is still looking for answers. This paper chronologically lists the research on ‘Size’ and why the question regarding ‘The Size Proxy’ has never been so relevant.
Before we talk about Blockchain disruption, let us talk about the implosion happening on Wall Street. The Realization that stock picking is dead [1] after decades of Active underperformance [2] has made beating the market an adventure sport, where only a few succeed. There was only one Peter Lynch [3], the active management is set to become 65% of the overall market [4], the high fees are gone [5] and if this was all not enough we have the ‘Do Nothing Strategy’ from Nevada’s Pension Fund Manager, Steve Edmundson who slashed the fee for external managers by nearly a 10th from an average USD 120 million to USD 18 million [6]. All this leaves little for the yachts and barely little for the golf club. Above all this, the technology is killing the incentive to make markets. It is the rise of the ‘Buy Side’ [7] and Virtu’s of the world, which never lose [8]. Basically, the party is over.
If you can explain your money management innovation (rule-based portfolios) to your mom, it is golden. My mom gets it. Succeeding in selling and marketing a new financial innovation just like any other innovation will be about design. If it is not intuitive, no overselling, branding and marketing money is going to stop the jumping from the ship.
Investment management which is worth USD 70 trillion can be seen like a fruit basket. The job of the fund manager was to select the fruits from the market and sell it to the investor. Global pensions are a part of this pool. Despite the important role fund managers play, there is a lot of confusion regarding financial theories and lack of standardization between investment management practices. Investment solutions are primarily for a rising market. There are limited solutions for a falling market. The investment solutions are primarily equity focussed. There are no standardized metrics to look at all asset classes together i.e. equities, commodities, bonds, currencies, alternatives. Academic thinking is also very equity focussed. ‘Size’ the most important factor explaining stock market returns is not understood well. The lack of standardization, solutions for an up trended market, equity skew is the ‘Fruit Basket Paradox’, a term that explains the fragmented nature of financial theories and the circular argument that rots the investment management business today.