Rixt Baerveldt

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Digital companies are becoming more common every year. Ten years ago, there was no such thing as Social Media and online shopping was barely used. Now, digital companies are the base of our network and our purchasing behavior. Especially Social Media networks like Facebook and Twitter have created a large customer base and you can probably not imagine your life without them.

The popularity of these digital companies are recognizable on their stock trends. Within 5 years, the stock of Facebook has increase over 10-fold, making the value of the company large. But where does it value come from? When you look at the balance sheet of digital companies, you will see that the company does not own a lot of tangible assets. Twitter has even reported its first (small) profit ever this year (Fiegerman, 2019). We have learned that the value of these digital businesses is party from the creation of Network Effects, the value of a product or service assigned by the user. The value increases according to the number of users. Basically, you are betting your money on a company that does not have (enough) resources and that therefore not able to cover costs if these shares will fall.

Research has shown that only 2.4% of investment decisions are based on a companies’ income statement. Where would the decision come from? You can look at the investments that are made or ongoing projects the company is working on, these are both factors that digital companies do not really have. The value of a digital company is assigned by the users. For me, this is comparable to a cryptocurrency; the value is determined by the public and the value of the currency can drop whenever the public thinks that the company does not have this value anymore. The same thing can happen with any digital company. As they do not have a lot of tangible value, their value completely depends on the the value that their investors and users assign to the company and its network. So why do people warn you not to invest in cryptocurrencies, but advice you to invest in digital companies? Is it naïve of us to do this? Or are there other differences that can explain the different views on these investments?

Stock price Facebook: https://finance.yahoo.com/quote/FB/?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAACYUgn8dG3I7q0L0svhDE18oFHlBq_lofB2pgsPcsroD-O–Z_5sh0s8TD2XAvIwwP6zzAtaEeVF7RUpu4In_KmF29tegLjV28d40sMXxBH-Z_N27aU5kzTWba0H84roPbn0EQq9zOVZxO8JOlS31KY4mDVNLsOT4LQ7LQMmZ6vu

Fiegerman (2019), ‘Twitter records its first annual profit, but it is losing millions of users’. CNN Business. Available at: https://edition.cnn.com/2019/02/07/tech/twitter-earnings-q4/index.html

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Artificial Intelligence (AI) has been exceeding expectations for years and is advancing in every industry. It has been proved that the best AI units are more than a thousand time smarter than the smartest human. Decisions can be made on the automatic learning that the machine has done based on all former decisions that have been made. AI is used in healthcare, finance, operations but it lacks in the investment industry. If AI is so helpful, why haven’t we seen a large adoption of AI when making investment decisions?

With high stakes in the investment industries, the risks are high and so are the potential opportunities. Until now, investment decisions never assured positive returns. Stock returns are the most accessible asset class and therefore using AI to predict stock returns should be possible, right? Unfortunately, financial time series are incredibly advanced and is has been found that the signal to noise ratio for investments are very low and therefore is it not possible for AI to create an algorithm for predictions on stocks. At this moment, that is to an extend that the benefits do not outweigh the costs of implementing AI.

Applying an off-the-shelf data set on a new algorithm often creates large generalization errors in AI and therefore makes the AI in investment decision making hard to implement. At this moment, investment companies are trying to include new information in algorithms, to find out what can influence and improve AI predictions on investment decisions. At the same time, the inconclusiveness of AI might mean that people, who have been the base of the decision-making dataset that AI learns from, have never made its decisions based on continuous factors and therefore I feel that making an investment may actually be the largest gamble there is.

An article of PWC makes it clear that there is another reason that AI is not in the industry. Investment companies try to implement AI, but fail to implement is as they have not created a AI strategy. Without this strategy for understanding how to use it, you take a lot of risk of implementing AI. When AI is implemented in the right way, this can increase returns in your investment companies and make more efficient decisions.

The investment industry has thus far not succeeded to find out what are the crucial factors in predicting stock returns. However, will the investments in AI ever give returns to the companies, or will it be useless to even try to implement the technology in the investment industry? And if it is impossible to implement, how safe are the safest investments when not even the smartest technology ever existed cannot even closely predict your returns?

Sources:
PWC (2019), Available at: https://www.pwc.com/us/en/industries/financial-services/library/artificial-intelligence-investing.html
Mike M (2019), Available at: https://medium.com/swlh/investing-with-ai-does-it-actually-work-58f2cb3c3a10

The value of kidding yourself

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Artificial Intelligence in Investment Decisions

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