Can AI Replace Human Discretion? Implications for executive decision-makers Damir Tokic Professor of Finance International University of Monaco October 29, 2018

Motivation My professional background: trading/investing (Series 3, Series 7) Recently, the largest investment management firm Blackrock announced that it will start replacing human stock pickers with Artificial Intelligence. 2/25/2019

Motivation My professional background: trading/investing (Series 3, Series 7). Recently, the largest investment management firm Blackrock announced that it will start replacing human stock pickers with Artificial Intelligence. Questions: Can AI replace human discretion in investing? 2/25/2019

Motivation My professional background: trading/investing (Series 3, Series 7). Recently, the largest investment management firm Blackrock announced that it will start replacing human stock pickers with Artificial Intelligence. Questions: Can AI replace human discretion in investing? If so, can AI replace human discretion in strategic planning? 2/25/2019

Motivation My professional background: trading/investing (Series 3, Series 7). Recently, the largest investment management firm Blackrock announced that it will start replacing human stock pickers with Artificial Intelligence. Questions: Can AI replace human discretion in investing? If so, can AI replace human discretion in strategic planning? What are the implications for executive decision-makers? 2/25/2019

Background Investing Passive Active Systematic Discretionary

Passive investing and AI Passive investing – long term strategy. Believes in market efficiency. Early-version Robo-advisors (AI) used to automatically profile the clients and allocate the funds to appropriate investments, as programmed by the human. Key attraction: cost saving

Active Systematic Trading and AI Active systematic trading – market timing based on technical analysis. Believes in market inefficiency. Systematic Robo-traders (AI) used to automatically execute the trading rule, as programmed by the human. Key attraction: discipline

Active Systematic Trading and AI

Discretionary investing Believes markets are inefficient, information is not properly priced. So, investor can find opportunities to time the market, or find undervalued assets, based on fundamental analysis.

Discretionary investing – two approches Top-down Bottoms-up

Discretionary investing – two approches

Discretionary investing – top down approach Also known as Global Macro analysis (systematic risk). Primarily based on analysis of: global monetary policy global fiscal policy geopolitical events Example: George Soros

Discretionary investing – bottoms up approach Also known as Stock Picking. Primarily based on fundamental analysis (firm-specific risk): Financial statements Ratio analysis Company news Example: Warren Buffet

Stock Picking and AI Blackrock is attempting to replace human Stock Pickers with the Artificial Intelligence program (the bottoms-up approach).

Stock Picking and AI Blackrock is attempting to replace human Stock Pickers with the Artificial Intelligence program (the bottoms-up approach). Why?

Stock Picking and AI Blackrock is attempting to replace human Stock Pickers with the Artificial Intelligence program (the bottoms-up approach). Why? To lower the fees in the active trading division (and prevent the fund outflows to less profitable divisions). To improve the performance – AI can outperform the human discretion.

Stock Picking and AI Blackrock is attempting to replace human Stock Pickers with the Artificial Intelligence program (the bottoms-up approach). Why? To lower the fees in the active trading division (and prevent the fund outflows to less profitable divisions). To improve the performance – AI can outperform the human discretion. Justification: BIG DATA

Stock Picking and Big Data The AI Stock Picker is essentially a sophisticated Stock Screener. The AI Stock Picker is able to instantaneously analyse: Thousands of financial statements and financial ratios. Published company news Social media posts Satellite images Real time web-page traffic Other. Thus, it eliminates the need for human financial analysts (decision-makers).

Stock Picking and Big Data The role of human: Program the AI Stock Picker with the corporate finance theory and financial analysis. Program the decision making rule or the parameters for desired stock pick. Example: AI Powered Equity ETF (AIEQ)

Can AI replace the human discretion in top-down approach? Technically, YES. The AI program can use econometric methods to extrapolate historical data. Also, the AI program can interpret economic forecast embedded in financial assets (for example yield curve). The AI program can also use as input the public economic forecast (for example IMF). In addition, an AI program can use as inputs major predictable trends and themes, such as demographics.

Top-down approach and AI (example)

Can AI replace the human discretion in top-down approach? An AI-powered Global Macro fund reduces the need for human economists and statisticians. The role of the human: Feed the AI program with econometrics, macroeconomics, and other Ph.D. level knowledge. Feed the AI program with data.

Strategic management and AI The strategic management process combines the bottoms-up and the top-down approaches. Executive decision-makers have to be able to foresee the business cycle (systematic), and the specific business fundamentals (firm specific). Note: Profitable business opportunity is also due to market inefficiency.

Can AI replace executive decision-makers? YES, an AI-powered Strategic Manager can more efficiently detect the supply/demand inefficiencies within the business cycle context. Also, it eliminates the agency costs (conflicts between shareholders, managers, and bondholders). An AI-powered Strategic Manager reduces the need for human executive decision- makers. The role of the human: Feed the AI program with the knowledge and data. Implement the strategy.

Strategic planning and AI Capital budgeting examples where an AI program could replace the human discretion: New product development New markets New plant/factory Machinery replacement These decisions also affect: Dividend policy Capital structure

The rise of Robo-Bosses Early-version Robo-advisors, were designed to improve efficiency, lower costs, and implement discipline. Human still retained the decision-making power. The new-versions of the AI powered Robo-advisors are designed to improve and possibly replace human decision-making. The role of human is reduced to feeding the AI program with data and knowledge.

Step forward: the rise of Robo-Policymakers An Artificial Intelligence Powered Central-Banker? Central bankers use the same fundamental data, macroeconomic theories, and econometric models to set the monetary policy. 100% guaranteed Central Bank independence?

Imagine this: Robo investor Robo boss Robo policymaker

Critical Analysis An AI-powered decision-maker is essentially a Rational Arbitrageur. (In investing, a rational arbitrageur estimates the intrinsic value and buys/sells when the market value differs from the intrinsic value, and thus, ensures Market Efficiency.)

Critical Analysis Thus, the systematic use the AI-powered decision-makers, would make all markets completely efficient. There would be no trading opportunities. There would be no profitable business opportunities.

Elements that will prevent the rise of Robo decision-makers: Legislation and lobbying Unpredictable geopolitics Corruption Justice system The rise of Robo-predators (fake data manufacturers, hackers)

Conclusion The machine can be fed with all possible human knowledge and all available data, but the machine can never consistently model human imperfections and inefficiencies. Thus, as long as the human imperfections are preserved, an AI-powered machine will not be able to replace the Human Discretion.