Man Makes Machine and Where It Goes Nobody Knows
People always seem surprised when they learn that more than 60% of financial market volumes are now driven by machines. Maybe it’s because as little as 25 years ago this figure was less than 5%. Or maybe the thought of machines taking over frightens people. Whatever the reason, fact remains that it is indeed a very high number and the question is, what effect has this had on the investment landscape? Do we make decisions differently now, are markets more efficient, is alpha disappearing?
To explore these very relevant topics, let us go back to the basics and look at why we turned to machines to begin with. You see, before computer driven algorithms and automated direct market execution systems, the investment world really was rather rudimentary, lacking in efficiency in all areas. Price discovery was poor. We had market makers and different local exchanges, which very simply meant that if you were closer to either, you knew about things before anyone else did. Fees, commissions, and costs were also unbelievably high and people used to pay as much as 1% just to buy a bond or a share.
Investment decision making was also rather basic, if you think about what we take for granted today. There was a time before you could just download the balance sheet of a given company or the bond offering of another. In those days, you had to request an annual report from a company you were interested in and then actually put together a spreadsheet to analyse certain financial numbers and ratios. As well, you could only ever focus on a few companies at a time, how else would you be able to get information on the thousands of other stocks and bonds globally, anyway?
When machines were brought into this world in the early nineties, they were a blessing. For anyone investing in the markets, machines brought greater transparency, lower commissions, and better executions. But moreover, they opened up a truly global investment world, where information could be accessed and compared instantly, where complex analysis could be performed across any number of different securities simultaneously and where machines could execute any rule-based instruction or program in nanoseconds. With so much technology, so much capital at work, and so many ‘smart’ machines now scouring every corner of the global financial markets, the ability to find inefficiencies and extract mispricings (alpha) have surely diminished.
Some say, that with artificial intelligence and so called machine learning, humans will soon completely disappear from the investment process. But we don’t think so. Clearly when it comes to doing multiplication for instance, a calculator will be much quicker and more precise than even the smartest human alive. But when it comes to making lateral decisions, the human mind is and will continue to be much superior to any machine. Why? Because humans can consider the impossible. Machines don’t do irrational, machines don’t do emotional and machines certainly don’t do different things when presented with the same input. Humans, whether by design or sheer ignorance, defy the odds every day. Life itself is a testimony to humans’ ability to achieve miracles.
So here is to randomness, here is to defying all logic, here is to being human and making the right decision at the wrong time or the wrong decision at the right time. For so long as humans behave as humans do, the world, life and the financial markets will be impossible to predict and machines will not take over the world.