During the Californian Gold Rush, folks who sold picks and shovels to the gold miners made more money than the miners themselves.
We have all heard of AI, that incessant talk about artificial intelligence and how it is going to change our lives. Well, AI has entered the world of stock picking. There is a lot of money to be made and like how the gold mining analogy goes, we know who is going to make all that money.
But why can’t AI-based stock picking systems work? In fact, why won’t any publicly accessible stock picking system work?
They don’t work because markets are a complex adaptive system. The variables that influence the prices are so many that it is hard to capture them with a neat little algorithm. And the mix of variables changes with time. New variables get born each day while the old ones die off and no system can reliably predict which ones they will be in advance.
And then there is the overfitting problem with any system that relies on past data. It can predict the past very well but cannot predict the future. Because the future evolves in ways the models cannot capture. Just think back to the Covid pandemic or the war in Ukraine or any other exogenous event that came out of the left field. No system can predict these events in advance. And even if they do, there is no way to know how stock prices will react to them.
And it is not like stock-picking systems didn’t exist before the advent of AI. They came in the form of newsletter writers who dispelled stock recommendations. Then there were the formulaic approaches to stock picking like the Dogs of the Dow where you rotated in and out of the 10 highest dividend paying stocks in the Dow each year. Then there is momentum and value investing, there is thematic investing…all these are built on some rules.
And once these rules start to show a profit, the world knows about them and then that edge is gone. This is how markets work. Excess profits invite competition, which then drives down those profits.
So, if you built a system that can reliably predict the best stocks to buy, I would not tell anyone. Because the moment the world knows about it, that system will stop working.
Thank you for your time.
Cover image credit – Cottonbro, Pexels