How Stock Picking Robots Will Become the Norm

Who’s the smartest person in history?

Surely Isaac Newton would be in the running.

He’s most famous for his theory of gravity. Almost all high school students know his three laws of motion.

He published one of the most important scientific works: the Principia Mathematica. He invented calculus, the first reflecting telescope, broke ground in optics and identified light as a source of colour.

‘…what truly separates Newton from other luminaries was his unparalleled creativity,’ Alex Berezow writes from Real Clear Science.

He created multiple tools that simply never existed before. For example, in order to study acceleration, the change in velocity, a tool beyond basic algebra was required. That tool, called the derivative, is the most basic function in calculus. It didn’t exist in the 17th Century. Newton invented it.

In order to find the area beneath a curve, another tool beyond basic algebra was needed. That tool, called integration, is the second most basic function in calculus. Like the derivative, it did not exist in the 17th Century. So, Newton invented it. He also invented a reflecting telescope and the ridges on coins, which serve as an anti-theft measure that prevents “coin clipping.”

Yet even a genius like Newton was no better at stock picking than anyone else.

In 1720, Newton ventured into the stock market to grow his wealth. He bought shares in the South Sea Company, one of the hottest stocks in England at the time.

Before the market soared to new heights, Newton got out. He pocketed a 100% return.

But months later, he got swept up in the wild enthusiasm. He jumped back into South Sea Company at a much higher price.

Shortly after, the market collapsed.

He lost almost all of his money and never spoke of it again.

Master of the universe paid millions for underperformance

It doesn’t hurt to be smart. But it’s not the deciding factor for whether you’ll be a great stock picker. This is something Warren Buffett talks about constantly.

You don’t need to be a rocket scientist. Investing in not a game where the guy with the 160 IQ beats the guy with a 130 IQ,’ Buffett told CNBC. But ‘rationality is essential.

Look at the hedge fund industry for example.

These titans of finance are praised for their brilliance. They’re paid millions each year to make money no matter what stocks, real estate, bonds or bitcoins might do.

Yet their brilliance only gets investors so far.

From the late 1990s, hedge fund returns have drifted down each year.

hedge fund returns

Source: Bloomberg

While I don’t doubt hedge fund managers are intelligent, many simply can’t live up to the hype, or the fees eating into their investor’s returns.

This all makes the argument for stock picking robots that much stronger.

Beat the market without the fees

A majority of hedge funds already underperform index funds. What’s worse is they charge good money to return such poor performance.

Some say it’s because we’ve (the US) been in a bull market since 2008. Such an environment isn’t great for hedge funds, which are supposed to act as a ‘hedge’ against the market. Yet I’d like to think millions in fees might get you something in return.

In my mind, hedge funds, on average, find it difficult to beat the market simply because they’re like most people. They give in to irrational behaviour, chase returns and aren’t able to sit still in a group of undervalued investments.

So why not remove the human element from the equation?

We already have computer stock pickers. Using inputs, a computer model can scour the market and buy stocks that have the potential to significantly appreciate.

But what if this computer could learn from its own mistakes?

This is exactly what the EquBot does. Powered by IBM’s Watson, the EquBot is an artificial intelligent (AI) ETF.

This AI analyses 6,000 stocks constantly, buying a portfolio of 30 to 70 stocks.

As reported by News.com.au:

So far, there has proved to be so much demand that the coverage universe it tracks had to be tweaked. With just $2.5 million in assets, it could invest in micro capitalization stocks without having a pronounced impact on their share movements.

‘“At its current size, however, especially with the higher turnover, the liquidity profile looks very different,” Armador said (co-founder of the EquBot). The fund now has a larger focus on companies with a higher market cap, which can be bought or sold with less of an impact on daily movement.

In December 2017, the AI ETF rose 3.5%, beating the S&P 500 by 1.7%.

Of course such a short-term return means nothing. But if the EquBot can build a market beating track record overtime, it could spell the end for human stock pickers.

Cheers,

Härje Ronngard,

Junior Analyst, Money Morning

PS: 2017 was a great year for investors. But what can you do to boost your returns for 2018? One way is to venture into small-caps. Investing in the smaller end of the market usually bears more risk. But the potential returns can be more than worth it.

To get you started on your small-cap hunt for 2018, check out these three companies trading on the ASX.


Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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