Don鈥檛 chase the financial singularity mirage
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In their new book 鈥淭he Incredible Shrinking Alpha,鈥 Larry E. Swedroe and Andrew L. Berkin describe an investment environment populated by increasingly sophisticated analysts who rely on big data, powerful computers, and scholarly research. With all this competition, the hurdles to achieving alpha [returns above a risk-adjusted benchmark, and thus a measure of success in picking individual investments] are getting higher and higher.
That conclusion raises a key question: will alpha eventually go to zero for every imaginable investment strategy? More fundamentally, is the day approaching when, thanks to so many smart people and smarter computers, financial markets really do become perfect, and we can just sit back, relax, and assume that all assets are priced correctly?
This imagined state of affairs might be called the financial singularity, analogous to the hypothetical future technological singularity, when computers replace human intelligence. The financial singularity implies that all investment decisions would be better left to a computer program, because the experts with their algorithms have figured out what drives market outcomes and reduced it to a seamless system.
Many believe that we are almost there. Even legendary investors like Warren Buffett, it is argued, are not really outperforming the market. In a recent paper, Buffett鈥檚 Alpha, Andrea Frazzini and David Kabiller of AQR Capital Management and Lasse Pedersen of Copenhagen Business School, conclude that Buffett is not generating significantly positive alpha if one takes account of certain lesser-known risk factors that have weighed heavily in his portfolio.
鈥楶erfect markets鈥
If that were true, investors would abandon, en masse, their efforts to ferret out mispricing in the market, because there wouldn鈥檛 be any. Market participants would rationally assume that every stock price is the true expected present value of future cash flows, with the appropriate rate of discount, and that those cash flows reflect fundamentals that everyone understands the same way. Investors鈥 decisions would diverge only because of differences in their personal situation.
There is a long-recognized problem with such perfect markets: no one would want to expend any effort to figure out what oscillations in prices mean for the future. Thirty-five years ago, in their classic paper, 鈥淥n the Impossibility of Informationally Efficient Markets,鈥 Sanford Grossman and Joseph Stiglitz presented this problem as a paradox: perfectly efficient markets require the effort of smart money to make them so; but if markets were perfect, smart money would give up trying.
The Grossman-Stiglitz conundrum seems less compelling in the financial singularity if we can imagine that computers direct all the investment decisions. Although alpha may be vanishingly small, it still represents enough profit to keep the computers running. But the real problem with this vision of financial singularity is not the Grossman-Stiglitz conundrum; it is that real-world markets are nowhere close to it. Computer enthusiasts are excited by things like the blockchain used by Bitcoin. But the futurists鈥 financial world bears no resemblance to today鈥檚 financial world.
Crazy theories
After all, the financial singularity implies that all prices would be based on such things as optimally projected future corporate profits and the correlation of profits with expected technological innovations and long-term demographic changes. But the smart money hardly ever talks in such ethereal terms.
In this context, it is difficult not to think of China鈥檚 recent stock-market plunge. News accounts depict hordes of emotional people trading on hunch and superstition. That looks a lot more like reality than all the talk of impending financial singularity.
Markets seem to be driven by stories, as I emphasize in my book 鈥淚rrational Exuberance.鈥 There are stories of great new eras and of looming depressions. There are fundamental stories about technology and declining resources. And there are stories about politics and bizarre conspiracies.
No one knows if these stories are true, but they take on a life of their own. Sometimes they go viral. When one has a heart-to-heart talk with many seemingly rational people, they turn out to have crazy theories. These people influence markets, because all other investors must reckon with them; and their craziness is not going away anytime soon.
Maybe Buffett鈥檚 past investing style can be captured in a trading algorithm today. But the true source of his success may consist in his understanding of when to abandon one method and devise another.
The idea of financial singularity may seem inspiring; but it is no less illusory than the rational Utopia that inspired generations of central planners.
Robert J. Shiller is a 2013 Nobel laureate in economics and a professor at Yale University. Copyright: Project Syndicate, 2015.
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