Outsource Probability to AI, Keep Convictions to Yourself

How humans and AI can work together in investing

The Deload explores my curiosities and experiments across AI, finance, and philosophy. Join over 2,100 readers:

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“What’s the role of humans as AI takes over the investing world?”

It’s the most popular question I get about Intelligent Alpha, and I’ve been thinking about it for almost two years.

One of the core insights from building investment portfolios at Intelligent Alpha is that AI’s superpower as an investor is lack of emotion. AI doesn’t get shaken in drawdowns, it doesn’t feel FOMO in rallies, it doesn’t overreact to meaningless news, and most news is meaningless. Instead, AI views the world in scores and probabilities. It rigidly calculates quantitative and qualitative elements of an investment in ways humans don’t and can’t.

But all superpowers create super weaknesses. AI’s lack of emotion is a weakness where a leap of faith is necessary because true conviction depends on the intangible, not the logical. Investing with conviction is where humans can win against AI.

What is Conviction?

Superior investment returns require doing something different than everyone else, and doing something different requires conviction. That’s because only the unconventional requires conviction. We don’t need conviction to do obvious things, just acceptance. Conviction must step in to support an unconventional idea when evidence ends.

My definition of conviction:

Conviction is the intangible belief in an unconventional idea necessary to spur action despite a lack of substantive evidence.

By that definition, conviction is a necessarily human state. Machines can’t engage in intangible beliefs. They rely on substantive evidence to take action. That’s their superpower and super weakness.

Conviction is also a binary state. Either a person has enough conviction to act or not. You can’t be half convicted. If conviction is fuzzy, the switch is off. Fuzzy conviction is the dangerous state where logic corrupts the necessary emotion to embrace the intangible belief. Fuzzy conviction falls into the realm of probability, and that’s a game humans will lose to AI on average.

Conviction x Evidence x Returns

Conviction needs to step in when evidence fails, so the amount of evidence available about an investment helps frame the required conviction.

You don’t need much conviction to invest in Microsoft. There’s unending evidence about why it’s a great company. If you get it wrong, you do a little worse than the market. Big deal.

You need more conviction to invest in a two-person startup than MSFT. If you get it wrong, you lose your entire investment. The trouble is there’s almost no evidence available at the earliest stages of investing, so while you need some conviction, you’d be fooling yourself to think you can find high conviction in a venture bet.

Between large public companies and startups is where you can find meaningful conviction in a balance of evidence and uncertainty.

Our conviction x evidence curve can also describe potential returns. The more evidence we have about something, the more conventional an idea it must be, and the lower the return is likely to be. We have lots of evidence about MSFT, but far less evidence for an investment in a new startup with two engineers and no customers. The potential return for the startup is orders of magnitude larger than MSFT because the conventionality (aka risk profile) is completely different.

Our blend of conviction, evidence, and potential return leaves us with three major investment categories where we can compare humans and AI:

• Modest conviction, low evidence, extreme return. This is venture capital.

• Low conviction, strong evidence, low return. This is active public equity.

• Strong conviction, modest evidence, strong return. This is private equity, activism, business ownership, etc.

Venture Capital (Modest Conviction, Extreme Return)

The limited evidence available to support venture capital investments makes it an instinctual effort mostly about reading people. You can find conviction in the founders but little else.

Because the startup investing world operates with so little evidence and therefore limited conviction, the optimal startup investing strategy is to build a broad portfolio that generates overall return through power law returns. Capture one really big winner, and it doesn’t matter if all the rest go to zero.

While the instinctual piece of startup investing elevates humans above AI, the limited ability to generate conviction and the effectiveness of a broad portfolio mean that AI could be a good startup investor. Broad portfolios invite probability to offset conviction. We’ll see several VC firms building AI to make investment decisions in the next few years, although gaining access to deals will be a human effort for a while yet.

Public Equity (Low Conviction, Low Return)

It takes minimum conviction to invest in most public companies (say above $5 billion in market cap), not just Microsoft. Public companies come with broadly available evidence to support an investment and the freedom of liquidity. Liquidity lowers the bar for conviction even further because investors can change their minds easily. Emotions are strong, convictions are fragile, and evidence appears to change frequently, so portfolios do too.

Because convictions in public markets are generally weak, portfolios are diversified to reflect it. Can an investor have conviction in 50 stocks? The investor might say he has conviction in his portfolio, but then he’s playing a game of statistics, not conviction, and we’re back to AI’s advantage.

The broad and consistent victory of indexes vs active managers shows that when investment strategies rely on weak convictions, statistics win. My experiments with dozens of strategies at Intelligent Alpha convince me that when you add intelligence to structure, you can do well in statistical games over the long run.

Other Equity (Strong Conviction, Strong Return)

The middle category is the most human-optimized segment of investing. It requires strong convictions built on modest supporting evidence with the potential for strong returns. This includes private equity, activist investing, and business ownership. The common thread of this middle category is that the investor brings with him some insight about an improvement he can make at the business that will generate returns. He’s not relying on others to figure it out for him as in the case of venture capital or public equity.

As a result of the alpha-generating insight and the willingness to get involved, high conviction bets tend to be highly concentrated. Concentration and activity go hand-in-hand with conviction. When you find that rare conviction, you should bet big and act accordingly.

AI might be able to do the analysis of a private equity analyst or an activist, but it will be a while before AI can perform the actions necessary to affect the outcome of the investment.

Human x AI

Anytime someone asks when AI will replace humans at some task, it ignores the reality of comparative advantage. To the extent humans are better at something, we can optimize for that rather than be relegated to obsolescence.

The human comparative advantage in investing is conviction. The challenge for us is that conviction must be rare. True and meaningful conviction should only happen a few times in a career. When we find conviction, it should be overwhelming and almost uncomfortable.

Most of the time, we’re in that fuzzy state where logic interferes with our instinct, and that’s where we make mistakes. If you’re not overwhelmed and uncomfortable, you’re not convicted, you’re just fooling yourself. You might be right sometimes in the fuzzy state, but then you’re dealing with the realm of probability, and that’s AI’s domain.

Whenever we’re in search of conviction, we should outsource our investing efforts to AI. That maximizes comparative advantage. AI can shine when dealing with probabilities, which is most of the time. Humans can shine when we find a rare unconventional idea that requires a convicted leap of faith, which is only once in a rare while.

Of this, I have strong conviction.

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Disclaimer. The Deload is a collection of my personal thoughts and ideas. My views here do not constitute investment advice. Content on the site is for educational purposes. The site does not represent the views of my firms, Intelligent Alpha or Deepwater Asset Management. I may reference companies in which Deepwater has an investment. See Intelligent Alpha’s full disclosures here. See Deepwater’s full disclosures here.

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