Close Close

Portfolio > ETFs > Broad Market

5 Scary Things That Won’t Crash the Market in Next 5 Years

Your article was successfully shared with the contacts you provided.

The CFA Institute recently solicited video submissions about the future of global investing, an irresistible lure to those inclined to share predictions from their “crystal ball.”  

December is a big month for predictions, and it isn’t uncommon to see forecasts of gloom and doom receive a lot of attention. My vision of the future incorporates skepticism about popular narratives, particularly the alarmist narratives that forecast impending doom. I expect a recession and bear market to occur at some point in the next five years, but I think it unlikely that we’ll experience a financial “meltdown” over that period.

My submission to the CFA Institute highlighted 5 disruptive forces influencing the future of global investing. I think these forces are vitally important, but will not “crash” the market in the next five years:

1. Artificial intelligence, big data and machine learning will be disruptive forces, but humans will still play an important role in providing investment management and financial advice.  

Quantitative algorithms are increasingly used to identify past patterns and subtle trends in large sets of data. Quantitative models may be superior to humans in looking through the rearview mirror, but humans still may be better equipped to identify future trends. AI, big data and machine learning may be less effective when outcomes are uncertain and subject to a high degree of randomness. There are numerous variables that influence the direction of markets, and it is easy to underestimate the human element of judgment.

Investor sentiment, government policy, geopolitics, and “luck” (including weather and other random influences) all may play a significant part in explaining investment performance. In many cases, decisions must be made in a context of unexpected developments, infrequent in nature and with limited historical data. Consequently, AI may not ever be a replacement for the judgment of a Warren Buffett, George Soros or Janet Yellen. 

Human advisors spend much of their time helping clients balance between goals that have financial as well as emotional elements. The emotional element is much harder to codify and capture for AI than the financial element, and typically requires trust, nonverbal insight and intuition. Empathy and trust are frequently cited as the most important attributes distinguishing human advisors from automated investment solutions, and those attributes aren’t likely to decline in importance. It’s often said that technology offers both threat and opportunity, but the cliché fits the current state of the investment management industry. Advances in technology represent a threat, but successful firms will embrace the opportunity by combining the judgment and creativity of humans with the systematic analytical capability of computers. 

In the words of renowned hedge fund investor Paul Tudor Jones, “No man is better than a machine, no machine is better than a man with a machine.”

2. Index funds will continue to gain market share, but actively managed funds will still play an important role in the market.

A Sanford Bernstein report, The Silent Road to Serfdom, portrayed passive management as a form of socialism. The Bernstein report characterized index investors as “free riders” benefiting from market prices set by an endangered species of active managers. Under a doomsday scenario, active funds would become “extinct” and be replaced entirely by passive funds.

Without the price-setting involvement of active managers, extreme deviations between market prices and the intrinsic value of securities would be inevitable. The rise of index funds is a significant investment trend, and annual outflows of hundreds of billions of dollars from actively managed funds show no sign of abating. However, the higher the proportion of passive investment in an asset class, the more likely that market prices will diverge from “fair” value. Increases in mispricing relative to fair value will inevitably draw money back into actively managed strategies. 

Although many mediocre managers will be driven out of more efficient asset classes such as U.S. large cap, it may still be difficult for active managers to beat their index. The elimination of some of the weaker investment managers may leave only the strongest active managers in competition with one another. The extreme competition among the best and the brightest of highly skilled managers could lead to a perverse environment in which the role of luck plays an even larger role in determining success. 

3. Increasingly, poor investing decisions will be challenged by behavioral finance.

Investors are not the rational creatures depicted in economic textbooks, and make counterproductive decisions at inopportune times. Some of the most noteworthy academic research in recent decades was about behavioral economics. Richard Thaler recently received a Nobel Prize in economics – in the words of the Royal Swedish Academy of Sciences, “his contributions have built a bridge between the economic and psychological analyses of individual decision-making.”

Thaler’s Nobel followed the Nobel awarded to Daniel Kahneman in 2002 for empirical findings challenging assumptions of human rationality prevailing in modern economic theory. Behavioral economics will become mainstream among investment managers and advisors. For example, Charles Schwab recently launched a tool designed to help advisors address emotional and cognitive biases. Schwab may be on the cutting edge of a trend in which advisors use behavioral economics to become more effective financial “therapists” protecting clients from their own worst instincts.

4. Market volatility hasn’t disappeared, but will be more episodic in nature.

Recent years have been generally placid, with low levels of economic and market volatility. The relative calm in the market has been a welcome contrast to the nonstop volatility in the political arena. The synchronized global expansion, low inflation and reasonably easy financial conditions support a low volatility environment. However, volatility may return with minimal notice.

Memories of the quant quake of 2007 and the flash crash of 2015 may have faded, but the risks that caused both market disruptions still lurk under the surface. The “Quant Quake” of August 2007 started when many alpha-oriented quant funds fell sharply. Quantitatively driven funds were using common metrics of value and momentum to identify opportunities, leading to considerable “crowding” of investments. As a liquidity-driven selloff began, the “race to the exit” by quant funds started a slump for quant strategies that lasted through 2009. 

The most recent flash crash occurred on Monday, Aug. 24, 2015. The Dow ended down 588 points, the worst single day loss since 2011. More than $600 billion traded hands and nearly 14 billion shares were traded on the NYSE and Nasdaq, making Aug. 24 the most active trading day since 2011. The flash crash highlighted shortcomings in market structure. Futures were halted twice before the markets opened; the VIX measure of volatility reached its highest level since the Greek crisis in 2011; and nearly half of stocks didn’t trade in the first 10 minutes of trading. There were more than 1,200 trading halts on Aug. 24; nearly 80% of them reportedly involved ETFs.

I’m not convinced that we’ve solved problems with market structure or crowded trades driven by algorithms, so I think it’s likely that volatility will resurface in the future. The new normal may be extended periods of low volatility when a dominant economic trend is in place, followed by spikes in volatility when the trend is disrupted.

5. Demographic challenges may not sentence the developed world to decades of slow growth.

Slow economic growth is thought to be the inevitable future for most of the world, with Japan’s slow growth demonstrating the challenges of an aging and highly indebted society.

Demographic trends are seemingly inexorable, with the mathematics of births, deaths and old age leading to a challenging environment for many developed-market countries. However, lessons from the past may illustrate the potential disruption of the conventional wisdom about growth in an aging world. People born in 1900 were likely to die before age 50, and most people in 1900 probably didn’t expect major changes in life expectancy during their lifetimes. However, advances in treatment of infectious diseases, declining infant deaths and cleaner water contributed to dramatic improvement of life expectancy in subsequent decades. 

It’s fair to consider the possibility that the demographic trends of today may be less inexorable than thought, as advances in gene editing technology and cancer immunotherapy could extend lives and improve late-in-life quality of life. Although gene editing and immuno-oncology are in early stages of development, the potential implications of longer, healthier lifespans would be game-changing for economic growth. The challenge for governments will be to address the unsustainable path of entitlement spending, which is perhaps the greatest potential threat to global economic health.

The importance of technology to the future of global investing is undeniable, with each of these five disruptive forces influenced or enabled by advances in technology. Artificial intelligence and machine learning support advances in trading techniques, development of traditional and alternative index investing strategies, while creating a “flatter” world in which market adjustments are likely to be more abrupt. Technology may also help create a world in which living to age 100 becomes commonplace. Behavioral finance is more of a “low-tech” endeavor, but technology will undoubtedly be central to efforts by financial advisors to become better financial “therapists” helping clients to avoid their worst behavioral impulses.

— Related on ThinkAdvisor: