Financial Singularity

Robert Shiller on the mirage of the financial singularity:

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’s 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. The implication is that Buffet’s genius could be replicated by a computer program that incorporates these factors.

If that were true, investors would abandon, en masse, their efforts to ferret out mispricing in the market, because there wouldn’t 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’ decisions would diverge only because of differences in their personal situation. For example, an automotive engineer might not buy automotive stocks – and might even short them – as a way to hedge the risk to his or her own particular type of human capital. Indeed, according to a computer crunching big data, this would be an optimal decision.

More here.

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