Wall Street's Dumb Obsession With Artificial Intelligence

One of the oldest investment cliches is fast becoming obsolete. For as long as stock trading has been around, brokers and financial advisers have preached long-term investing, urging clients to adopt a 10-year horizon to smooth out the inevitable market volatility that effects returns.

As proof of their theory, investment counselors haul out charts showing that over a decade, despite economic ups and downs, stocks average annual returns of around seven to nine percent. The premise is soothing to investors seeking predictability in the performance of their investments.  

However, in the last ten years the stock market has failed to deliver anything approaching those returns. The Standard & Poor's 500 posted a skimpy annual return of 0.4 percent between August 1, 2000, and August 31 of this year. During this ten-year period, the hallmark of the market has been its unpredictability.

The financial industry can dredge up a laundry list of explanations for the market volatility, most notably the near collapse of the country's biggest banks and financial institutions.  Without overlooking those problems, they don't fully explain the market chaos.  Although its hardly ever mentioned, one of the chief contributors to market turbulence is the introduction of artificial intelligence on Wall Street.

Beginning more than a decade ago, big investment houses, financial institutions and brokerage firms began using computers and algorithmic programs to buy and sell large blocks of stock that traditionally were shopped by traders on the floor of Wall Street exchanges. It was done in the name of speed and cost savings as securities firms were able to slash the number of traders they employed.

Based on this success, every financial company began recruiting mathematicians, engineers and computer science professionals, while dumping millions of dollars into computing, networking and software. As a result, lightning-fast super computers began assuming a larger role in discovering stock opportunities, identifying subtle market trends, figuring when to execute trades and cracking the trading strategies of their competitors.

These moves turned the financial industry on its head.  Major financial firms began relying more heavily on artificial intelligence than human intelligence for every conceivable task.  The trend has become even more pronounced in the last two years with computer-aided trading now accounting for about 70 percent of the total volume on the stock exchanges.

But this reliance has come at a steep cost. Stocks have lost $4 trillion in value since the peak in 2007 as huge market swings have dealt crippling blows.   The largest was logged May 6 of last year when the Dow Jones Industrial Average plummeted 573 points in a mere five minutes.  Most market watchers now believe the so-called "flash crash" was created by powerful, swift computers that spiraled out of control in a series of cascading trades based on algorithmic formulas. In essence, the machines took over the market.

In the aftermath of the crash, dizzying drops in the stock market have become routine and impossible to predict. For instance, this year the S&P 500 has lost more than two percent of its value on 15 days, 14 of those occurring just since July. Stock volatility indices have reached levels last experienced at the trough of the bear market in 2009.

Explaining the dramatic dips is getting harder for financial pros, leading investors to conclude that the stock market is incomprehensible. That has fueled an investor stampede for the exists. In 2010, investors yanked $37 billion out of the market. This year has witnessed further erosion in market confidence as investors have fled stocks for the safety of gold, bonds and other financial instruments.

For a good laugh, listen each day as financial pundits stumble to dissect the market's performance.  They offer up reasons like natural disasters, world debt woes, labor unrest, or insurrections in some obscure country to explain market oscillations.  No doubt these forces and others have impacted the stocks of some companies, but the truth is that computerized investing and trading has fueled much of the dysfunction on the exchanges.

That is because every process from finding the right stock to the timing of selling and buying is done without human involvement.  It is true that humans wrote the software codes and developed the algorithms for the computers, but machines are increasingly driving the stock market unfettered by human intervention.

This is not a comforting thought for the millions of Americans invested in stocks through 401K plans, pensions or mutual funds. Some are calling for the government to get more involved beyond its traditional watchdog role. But the solution lies not in Washington.

It is the responsibility of the financial industry to restore investor confidence by addressing the volatility issue as it relates to computerized trading.  The answer is not to shelve the computers because prudent use of technology allows the market to function efficiently.

However, the industry needs to curb its obsession with technology and ensure that human intelligence has the ability to override computerized trading decisions.  If they fail to do so, then individual investors have every right to Occupy Wall Street.  Unlike the current crop of demonstrators, investors would actually have a legitimate reason for their protest.