The Psy-Fi Blog: Can Software Beat Penny-Flippers?

"Am I doing better than I could do by flipping pennies?" - Paul Meehl

Denial is Futile

The Abnormal Returns website recently highlighted an interesting little spat on the blogosphere, as commentators argue over the benefits of software based investment advice. It’s a trend with only one outcome, one that probably doesn’t do investors any good, but equally one that’s sadly inevitable.

What’s more interesting, though, is the creaking movements of tectonic plates as various commentators position themselves uneasily on the cusp of a disruptive change. You can see the status quo bias at work, but like it or not, change is coming: the markets won’t be denied.

Disruptive Finance

Global electronic networking has changed the business environment irrevocably, destroying some business models and badly disrupting others. The financial industry is no less prone to this than the music, newspaper, publishing or sundry others, but this hasn’t necessarily resulted in better results for investors (see: Moats Unbundled).

Take just two innovations: low-cost internet brokers and low-cost market capitalization index trackers. We can praise these innovations to the sky because they have genuinely forced open an industry characterized by dubious insider dealing and crazy economics, but neither has self-evidently improved investor returns.

Low-cost, Low-intellect, Low returns

Low-cost internet share dealing has been spectacularly successful, and has provided instant market access to millions of investors who otherwise had to deal with slow and opaque services. These investors have used this new power with the responsibility one would associate with a three year old let loose in a candy shop. I’ve regularly flagged up the research showing that most investors simply trade away any gains they might get, and the evidence strongly suggests that traders who moved from a non-internet broker to an on-line one have simply worsened their performance (see: The 160 Billion Dollar Bezzle).

Low-cost market capitalization index trackers have also been a huge success but are proving equally problematic. When these were relatively small, compared to the size of the market, their parasitic nature meant that they simply followed stock fundamentals: they track sentiment, that’s their purpose. Now that the sheer weight of funds being pumped into passive investments is significant compared to the overall market we’re seeing them wag the market (see: Hubble, Bubble, Index Trouble).

It’s all very well to argue that index trackers are simply the least worst option – but when they reward overpriced and overhyped stocks with investment flows then they simply widen the divergence of growth and value stocks. All bubbles end badly, and we never see the approaching pin: if we did, there’d be no bubble.

The idea that positive innovations such as these can yield perverse and damaging results for investors is counter-intuitive but true. We’ve exchanged one set of biases – those self-serving ones held by the intermediaries who’ve been replaced by low-cost market access – for another – those held by the untrained, unwashed masses of private investors who are deludedly trying to beat, or even just track, the markets.

Unintended

In fact, it’s even worse than this, because the low margin business models introduced on the back of this revolution has encouraged the creation of ever-more complex derivatives in an effort to find new ways of generating revenue. The idea is that these will help investors reduce risk, the reality is that most people don’t know how to use them. As Josh Brown comments in Backstage Wall Street

“One of the key unintended consequences of the zeroing out of full-service commissions has been an explosion of structured products and other questionable wares … When brokers could no longer charge 2 or 3 percent on generic stock trades anymore, they simply turned to these other lucrative lines of business. In doing so they created a positively systemic amount of collateral damage.”

So what of the replacement of human advisers by automated ones, as outlined by Nick Shalek? Well, whether you like it or not this simply extends an idea that’s been gaining traction ever since Paul Meehl published Clinical vs. Statistical Prediction back in 1954. What Meehl showed was that statistical predictions were always at least as good as expert judgement and often better. Even when only as good they were a great deal more cost-effective.

Meehl's Envelope

Daniel Kahneman devotes a chapter of Thinking, Fast and Slowto the results of Meehl’s work. It’s absolutely required reading for anyone who thinks that experts can provide much value at all in making tricky judgement calls in situations characterized by uncertainty:

“The important conclusion from this research is that an algorithm that is constructed on the back of an envelope is often good enough to compete with an optimally weighted formula, and certainly good enough to outodo expert judgement. This logic can be applied in many domains, ranging from the selection of stocks by portfolio managers to the choices of medical treatments by doctors or patients”

Kahneman also reviews the intense hostility of the experts to the idea that their judgement should be replaced by machines. This is understandable, and self-serving. History is littered with experts who refused to accept new evidence that their careers were based on fallacies. We can understand this, but many of these people have cost the lives of thousands: for example, when John Snow traced outbreaks of cholera in London to a specific standpipe the experts refused to accept his theory of oral-fecal disease transmission (see: Dying to Invest).

Backdoor Efficiency

So, of course, there will be resistance to the idea that investment expertise can be replaced by computers, much of it targeted at the idea that the algorithms won't work. This argument is also self-serving, perfectly understandable and completely doomed to fail. In market led situations people have already shown themselves all-too-eager to exchange costly intermediaries for cheap self-management. Initial reservations about the use of algorithms will drop along with prices, and initial results will be as good, and probably better, than what they replace.

These systems will change the markets, because they’ll change the way that people invest. As many of them will use Markowitz’s portfolio theory we may yet see markets becoming more efficient (see: Markowitz's Portfolio Theory and the Efficient Frontier). This, of course, also seems counterintuitive, but would be in line with the experience of other innovations – when the Black-Scholes equation became widely understood options pricing moved into line with it (see: Is Self-Interest Self-Fulfilling?). Getting people to implement efficient portfolios is not necessarily a bad thing, as long as they understand the risks; an unlikely proposition, then.

Change is Constant

However, just like the other low-cost innovations this revolution will seed a whole new set of problems as the technology becomes widespread. Just as index trackers started out by tracking markets but are now moving them, so algorithmic expertise will lead to unforeseeable adaptations of the markets. Of course, algorithmic expert investment advice may then turn out to be the counter to algorithmic index tracking, leading to an interesting ebb and flow between growth and value stocks. Maybe.

Like many disruptive technologies this revolution will destroy existing business models and create new, low-margin and intensely competitive ones. It won’t make people better investors, though. We’ll simply replace one set of self-serving individuals with another and cause the displaced to go off in search of new ways of making money. The experts will fight tooth and nail against this change as they have in every other sphere of influence, but only where they have been able to exert control, such as in clinical judgement, have they been able to resist the tidal force of lower-costs and better results. Investment advisers have no such protection and, like it or not, change is coming.