When I started in this business, individual investors dominated daily trading. Now, even decisions by professional stock pickers are eclipsed by passively run pools of capital, governed by algorithms executed by artificial intelligence.
The consensus seems to be this is simply the next phase of evolution. After all, computers trade at multiples the speed of ordinary humans and without the emotion that’s often the biggest failing of investors.
The problem is capital governed by algorithm faces the same conundrum as do large funds run by managers: The larger the pool, the smaller the list of stocks available to trade without moving the market, no matter how sophisticated the programming. And that’s leaving aside the fact that many algorithms are written with similar objectives–i.e. to beat the S&P 500 and other benchmarks—and are therefore likely to take similar actions at the same time.
We’ve yet to see passive investing strategies tested in a crisis. But we already know that over any meaningful period of years, pools of capital using passive strategies such as the Vanguard Target Retirement funds have dramatically underperformed market averages. We also know that price momentum created by passive strategies creates opportunities to buy lower and sell higher than in previous market cycles.
Taking advantage does require knowing whether a fallen company is still strong on the inside, or if a high flyer has exceeded any reasonable gauge of value and is likely to take a tumble. But by following a disciplined strategy of seeking quality and waiting for the right price, we’re going to find many more opportunities like March Focus stock AES Corp (NYSE: AES), which has since returned upwards of 30 percent.
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