AI: Artificial Intelligence or Artificial Idiocy?

When I first set up our business I stopped by the Army Surplus Store and purchased a used typewriter. My second stop was at an office supply store where I bought some index cards, pencils, pens, tablets, typing paper, and a few sheets of carbon paper.

Last, I stopped by the phone company to set up my communication system. It consisted of two lines and a rotary phone with a button to switch between lines.

My research material included the stock and bond guides from Standard & Poor’s along with a subscription to the Value Line Investment Survey.

What I personally added to these few items was a college degree and a license to sell securities. The investment intelligence I possessed was next to nothing. I guess you could say that in those days I truly did use artificial intelligence in recommending securities.

Oh, how times have changed. Today, a young person can enter the investment business armed with decades of knowledge available at their fingertips. They don’t even have to understand how to interpret that knowledge, as a computer program can, within seconds, kick out recommended investment products conveniently allocated into a total portfolio. This approach, the use of computers to make investment decisions, falls under the large umbrella of computer science we now call artificial intelligence.

It seems that we are at a point in time where a large portion of investors believe that machines can replace human intelligence in the field of portfolio management, resulting in higher risk adjusted returns at a substantially lower cost. Which brings us to Nobel Memorial Prize winner Harry Markowitz, whose words gave us the title to this month’s letter.

Dr. Markowitz’s influence started with his Doctoral Thesis titled “Portfolio Selection,” published in the March 1952 edition of the Journal of Finance. It is this paper that changed the world of portfolio management, providing a quantitative method to satisfy the risk averse nature of human investors. The basic assumptions were that people are only willing to take on risk if the expected payoff for taking the extra risk is a higher total return, and that any security’s risk and return characteristics by themselves are not as important as how each security adds to the total portfolio’s risk and return. This work became known as “Modern Portfolio Theory” (MPT), and by Markowitz’s own words “created the portfolio theory industry.”

This is a logical approach to portfolio management. Its popularity grew slowly at first. In my opinion, it took the decline in the cost of computing power to bring the theory to the masses. After all, individuals and their advisors do not have the time nor skill to compute the mathematical calculations necessary to quantify individual security risk and the expected rate of return of each security. Today’s computers can accomplish these calculations on thousands of securities in milliseconds.