"The romantic mirage that man-plus-machine is better than machine-without-man has been disproved in many disciplines."
Systematic investing is nothing new. Renaissance Technologies – the Long Island based hedge fund – pioneered quantitative and systematic trading strategies in the early 1980s. Such was their success, founder Jim Simons’ biographer hailed him as The Man Who Solved the Market.1
What is new is the scale these types of strategies have grown to and their prevalence, exerting ever greater influence on markets.
Is the victory of machine over man inevitable when it comes to investing too? In the very long run, probably. But, for the foreseeable future, we do not think so. “Ah,” the cynical reader might suggest, “of course an active investment manager would say that.”
We might. And so it falls upon me to explain why.
OUR TWO CENTS
Two main contentions emerge from our thinking:
Firstly, while shorter-term investing is best done by machines, we think longer-term investing is still best done by humans.
Secondly, we think the rise of the machines in investing might hand more opportunities to active investors with a long-term focus.
This second point needs some immediate attention, before laying out the reasons for our thinking in more detail. In brief, machines’ focus is typically on short-term drivers. And those are frequently unrelated to drivers that dominate in the long term. Therefore, a disciplined medium-to-long-term investor could actually benefit from the rise of systematic investing due to the potential for more short-term dislocations. Patient and strong hands might be required: a market with a heavy participation of machines might go further off-piste for longer than a market without.
DIFFERENT DAYS, DIFFERENT DRIVERS
The rise of systematic investing does not change the fact that, over the long term, fundamentals matter most. This idea was most famously captured by Benjamin Graham and David Dodd, who in 1934 drew the distinction between the market as a voting machine in the short run and as a weighing machine in the long run. Figure 1 shows how the market weighs fundamentals over the long term.
And it is in the weighing we think patient active investors can still prevail. Machines concentrate on the voting and the shorter term because that allows for more frequent investing. And humans cannot compete on volume or frequency of trading.
The investing factors that matter most in the long run, namely valuations and long-term growth, are much less important in the short term.
Nobel prize winning economist Robert J. Shiller laid the theoretical groundwork to explain this short-term stock market behaviour even before the arrival of machines as a dominant force. He studied instances in which short-term fluctuations in stock prices exceed what is justifiable for fundamental reasons, which he described and quantified as ‘excess volatility’. He also noted the inherent impossibility of forecasting these short-term moves.
It is exactly because long-term drivers are very different from the collection of drivers that matter most in the short term, combined with machines’ concentration on the short term, that active investors can have an advantage by focusing on the long term. Moreover, machines’ short-term focus might create even more dislocations from those long-term fundamentals. More excess volatility, in Shiller’s words.
1 Zuckerman (2019), The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution