How Will AI Perform During the Next Market Downturn?
Despite the outperformance of funds and strategies using artificial intelligence, many grizzled Wall Street veterans believe that their vulnerabilities have been masked by the low-volatility, bull market of the past few years.They point to previous blowups of automated strategies, such as portfolio insurance in the late 1980s, Long-Term Capital Management in 1998, and many quant funds in 2007 during the subprime meltdown. Each of these strategies worked well during the preceding bull market but fell apart when prices fell steeply.
Bear markets differ from bull markets in that the predominant emotion is fear instead of greed. Prices go from generously valued during bull markets to undervalued as investors and traders become overly pessimistic on the future of the economy. Another factor contributing to the selling is that companies or traders using excessive leverage become forced sellers due to liquidation.
It is undoubtedly true that AI has not yet been thoroughly tested in bear market conditions; however, there are two reasons to believe that AI’s outperformance will only accelerate during the next market downturn.
Lack of Experience
Although AI has not been tested in a real-time bear market or market crash, AI programs are run through billions of simulations encompassing nearly every type of scenario. The AI adjusts its methods regarding risk, position sizing, and asset selection to continually make winning trades.
While the last few years have been placid regarding drawdowns, the market has been challenging. Most actively managed funds have failed to keep up with the major averages. Most of the performance of indexes has been due to the outperformance of a small group of stocks. There have been unexpected events with surprising market reactions, such as Brexit and the US election.
Nevertheless, AI has thrived even as human traders have struggled. Money continually flows out of actively managed funds and into passive funds. AI has outperformed while experienced traders have floundered.
Lack of Emotions
During bear markets, the winners are the ones who remain unfazed by the emotions driving market action. They are able to buy securities with depressed prices whose fundamentals remain strong. They are able to hold these securities until prices reach fair value. Think of Warren Buffett in the fall of 2008 buying up financial stocks and preferred shares while many were worrying about the collapse of the financial system.
Only a small number of humans are able to do this continually. AI has a better chance of doing this because it is not driven by feelings. It is able to act rationally in every decision it makes. Based on this, it is fair to believe that AI’s real value will shine during market downturns when the market becomes more inefficient.
