AI

How to Benefit from AI (Artificial Intelligence) Without a Lost Decade

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Quiz!

Which of these investments can do well thanks to the AI revolution? (There may be multiple answers.)

  1. An Asian renewable energy company generating very cheap electricity.
  2. A company whose stock went up 1,000% in recent years.
  3. A trucking company using AI to improve many aspects of its operation.

How to Benefit from AI (Artificial Intelligence) Without a Lost Decade

AI is having a big impact, with an expectation for a transformation that would improve lives all around the world. The promise of AI led to outsized gains for technology companies. The excitement pushed prices higher much faster than actual earnings and book values (intrinsic values) of some of these companies. The effect surpassed the dot-com boom, with S&P 500 Price/Book (P/B) even higher than the peak of 2000, and is now the biggest seen since 1929, the onset of the Great Depression.

This creates a dilemma: Do you buy companies that are involved in a worldwide transformation, hoping to benefit from earning growth, or do you avoid them given that the price growth surpassed the actual earnings many times over? The most recent case when prices (relative to book values, or P/B) reached close to the extreme of today, was during a lost decade – a 10-year decline of 30% for the S&P 500, and a 14-year decline-to-recovery for the Nasdaq. The Nasdaq lost 78% over a grueling 2.5 years. This was the result of very successful companies continuing to be successful while adjusting prices to be more in line with reality.

While different bubbles pop at different levels, the current bubble has a solution that avoids the big risk while still aiming high. The reason it is possible is that there are plenty of stocks and entire stock markets (countries) that are not priced high. One solution is to invest in deep-value (much lower than typical P/B) companies around the world, emphasizing non-US stocks (international and emerging markets), and diversifying across sectors. The benefits:

  1. Efficiency broadly:  AI makes companies across all sectors and economies more efficient, increasing their values.  The benefit depends on the speed of adoption, and the ability to adopt.  With company and sector diversification, you can enjoy an overall benefit, without the risk of a company- or sector-specific bet.
  1. Spread:  As happens typically in tech cycles, the world will transition from a few early AI developers, to competition (e.g. DeepSeek).  This punishes companies with valuations that reflect expectation for eternal dominance, and rewards new entrants that start with low P/B.

Quiz Answer:

Which of these investments can do well thanks to the AI revolution? (There may be multiple answers.)

  1. An Asian renewable energy company generating very cheap electricity. [Correct Answer]
  2. A company whose stock went up 1,000% in recent years.
  3. A trucking company using AI to improve many aspects of its operation. [Correct Answer]

Explanations:

  1. AI consumes substantial energy. A company with competitive pricing along with the appeal of renewable energy can enjoy growing market share in a market with growing overall demand.
  2. Just because a company’s stock surged, we can’t know what its future will be. It could still be underpriced, or it could have become overpriced through people chasing past gains without studying the merits of the investment, including the company’s earnings and book value relative to its current price.
  3. Many companies may benefit from AI in multiple ways. Those who implement it smartly can get a big benefit, regardless of their sector, including trucking companies.
Disclosures Including Backtested Performance Data

My Personal Experience with the Recency Bias

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Quiz!

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one.

My Personal Experience with the Recency Bias

What is the Recency Bias? It is making decisions based on recent events, with the expectation that they will continue.

How can the Recency Bias hurt investors? Most investments are cyclical, while the recency bias assumes no cycles. Common harm is buying high after unusual gains or selling low after unusual declines. When done repeatedly, it can lead to long-term underperformance of a simple buy-and-hold strategy.

Are there less obvious cases of Recency Bias hurting investors? Yes. Many investors are disciplined enough to hold onto their investments at low points, but they may wait for gains before investing new money. Missing a 1% or 2% gain is nearly harmless. But some investors wait for more and more evidence. Once they see (and miss) 20% or 30% gains, some wait to buy at a dip, and some wait for more evidence of gains. Only after seeing 50% to 100% gains, some feel that the gains are here to stay, and invest after missing out on huge gains. The damage is far worse than simply missing gains, leading to a negative snowball. The delayed investment hurts their personal returns, they think that their investments are worse than reality, so they stay less committed to them, hurting their returns even further, cycle after cycle.

Did I ever experience the Recency Bias? Yes & no. When trying to think about the likely returns of an investment in the next 10 years, I know that it’s likely to be different than the past 10 years, given studies of investment cycles and valuation measures. But, in anomalous times, where a cycle gets stretched longer than usual, I am tempted to temper my expectations for the next leg of the cycle. I recognize that real life works the opposite – the longer we have an anomaly, the stronger the reversal tends to be. Examples of my recency bias:

  1. When looking at the raw data, it is rational to expect the S&P 500 to lose value over the next 10 years. But the recency bias leads me to believe it may get low positive returns.
  2. When looking at the raw data, it is rational to expect non-US Value (low Price/Book) stocks to enjoy unusually high returns over the next 10 years. But I catch myself sometimes expecting only average returns.

How damaging can the Recency Bias be? The examples I gave right above are not too harmful. They don’t lead me to make decisions that are opposite of rational, so I can live with them. The harm comes from an expectation opposite of rational, that leads to decisions that are very likely to fail. Here are examples:

  1. Expecting the S&P 500 to average more than 10% per year in the next 10 years, or even 6% or 8%.
  2. Expecting low interest rates in the next few years.
  3. Expecting AI-focused companies that reached extreme valuations to significantly outperform the rest of the market in the next 10 years.

How do I avoid big harm by the Recency Bias? I base my expectations based on a combination of:

  1. Full cycle, long-term behavior.
  2. Logic.
  3. Valuations (e.g. Price/Book) today relative to typical in the past.

Quiz Answer:

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year. [The Correct Answer]

Explanation: High growth diversified investments tend to be cyclical, with reversals being more common than not after 10 years.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one. [The Correct Answer]

Explanation: When above/below trend continues beyond 10 years, reversals continue to be the more common case, with greater odds and magnitude.

Read this month’s article to find out what leads people to pick the other option for both questions.

Disclosures Including Backtested Performance Data