Our previous blog discussed how Artificial Intelligence is taking over the tasks of humans even in the financial markets. Algorithmic trading and quant-fund management are a few examples. However, I believe that AI can be a bane for the financial markets. Overuse of Artificial Intelligence can actually wear down abnormal profits that investors make these days using valuation or even speculation.
Readers having a background in finance may have heard about this famous theory called, “The Efficient market hypothesis.” Non-Finance readers do not worry, the theory is not as difficult as the name sounds.
By Definition,
The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.
In other words, with all the information that is available in the market, it is assumed that the share prices indicate the fair value or the true value of the company. This means the value of the shares can neither be undervalued nor overvalued. Value investors, who tend to fundamentally analyze the company and look for stocks that do not reflect true value, will not be able to make abnormal or “bumper profits” if the markets are efficient.
However, the question is, “What is an efficient market? How can markets be efficient?”
Efficiency can be of three types:
Allocative Efficiency: Allocative Efficiency can be achieved when the companies in the economy allocate their limited resources to projects which are most profitable and the best for all the stakeholders, thereby contributing to economic growth. However, the EMH only talks about the market and not the economy as a whole, hence we are not going to discuss this type of efficiency.
Operational Efficiency: A stock market is said to be operationally efficient when there are no hindrances in the operations of the market. Some types of hindrances can be, technical or monetary. The use of the latest technology in markets today is slowly removing such hindrances. For example, before the dematerialization of shares, investors came to know about the prices only a day after when they were reflected in the newspaper, however, today investors can access the share prices for free which refresh every few seconds. This was one of the major turning points for the modern markets. The cost of investing also contributes to operational efficiency. Brokerage fees, account maintenance charges, portfolio management fees have all gone done after the advent of technology making markets even more efficient. But remember, the markets are not fully operationally efficient, because one cannot invest in the markets for absolutely no fees!
Informational Efficiency: If all the stock prices perfectly reflect all the available information in the market, then the market is said to be informationally efficient. For example, as soon as a company declares its earnings or any other important news, the market prices of the company’s stocks will adjust accordingly and reflect the true value of the company. While it may look like markets are informationally efficient, they are not! There are a few reasons why markets are not always informationally efficient:
Time Lag: there is a general difference between the time when the information was released and when it is reflected in the prices of the shares. This lets a lot of speculators and investors make huge profits.
Subjective Analysis: Analysts have different ways of analyzing the companies, technically or fundamentally. This means the value that investor A perceives for Apple Inc. will be different from the value perceived by investor B. If A thinks that the company is undervalued, they will want to purchase the shares of Apple, while if B thinks that the company is overvalued, they will want to short the same shares to investor A. Stock markets are a Zero-Sum game, which means if one is earning money, the other party is losing the same amount.
Human Bias: Humans have an in-built bias when it comes to investing in companies that they like or do not like. For example, “It’s Reliance! It’s Tesla! The prices of these stocks are always going to go up.”
There are many more reasons that contribute to informational inefficiencies in the market, like underdeveloped markets, lack of proper communication techniques, etc.
Introduction of technology and its impact on efficiency.
If the readers look back to the forms of efficiencies and ponder upon the ways to remove all of the inefficiencies from the market, the best way to do it is to make use of advanced technologies. Modern technologies can help in improving communication, reducing cost, reflecting real-time data, completely removing operational inefficiencies.
With better communication and the advancement of AI abilities, machines can also reduce the ‘time lag’ between the dissemination of information and the reflection of prices. Machines are becoming better every day, which means they can now fundamentally analyze a company. YES! You read it right, companies have started deploying models that can analyze the fundamentals of a company (financial ratio, predicting revenues, analyze annual reports, etc.) making the analysis less and less subjective. The predictions made by model A deployed by a research company will be very similar to predictions made by model B deployed by another company. This will help remove informational inefficiencies as well.
Do you now realize where am I heading?
So, while I was studying EMH in my CFA along with the programming analytics course at my university, a question hit my mind; What if technology starts getting used by all the investors in the market, which makes it even more accurate, will markets become almost perfectly efficient?
It is established that the use of technology will reduce inefficiencies make the markets more developed. Relating this with the EMH, technology would help the price reflect all the information that is available in the market. Hence, fundamentalists and Technical Analysts will not be able to find stocks that are mispriced by the market. This will restrict the investors from ‘beating the market’, a big NO-NO to bumper profits!
Does this mean it will be pointless to invest in the stock markets in the future?
No, it is not completely true. Markets always reward you for the amount of risk that you take. When you invest in a company, you put your money at stake, and there are a lot of risks involved. What if the company fails to meet its short-term goals? What if the company runs into losses? What if the company goes bankrupt? What if no one wants to buy the stock that I have? If markets were to become perfectly efficient, an investor still would earn profits, only that the profits will not be more than the amount of risk taken. In other words, an investor cannot earn ‘abnormal profits’ but only ‘normal profits.
To put it logically,
Return = Risk free rate (rate on government bonds) + Liquidity premium + Default risk premium
The total return will equate to the premiums earned from each type of risk you have taken. Hence, investors may not be able to earn more than the returns on the underlying index.
As Artificial Intelligence is becoming ever better, in the future it will be able to analyze risks and predict returns and eventually manage portfolios on its own, removing the ‘human bias’, ‘time lag’, and ‘subjectivity’ to a great extent. Active management of portfolios may become the thing of the past. (you never know!)
Active management of portfolios may become the thing of the past.
Imagine a world where there are no equity research analysts, no stockbrokers, no financial advisors, just machines telling you which stocks to buy and which to sell! How will such a market look like? Would you want to invest in a market that does not let you earn profits more than the market return?
Think about it while we come back with more such interesting takes on finance on our blogs, and remember to:
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