Michael Kearns explains why algorithms dominate short-term trading on sub-second to multi-day timescales but struggle with long-horizon investing like Warren Buffett's. Algorithms excel with exchange data, but macro investing requires tracking economic cycles, political risk, and wars. Kearns remains skeptical about automating long-term investing soon.
You've worn many hats. One of which, the one that first caused me to become a big fan of your work many years ago is algorithmic trading. So I have to just ask a question about this because you have so much fascinating work there in the 21st century. What role do you think algorithms have in the space of trading investment in the financial sector?
Yeah, it's a good question. I mean, in the time I've spent on Wall street and in finance, I've seen a clear progression. And I think it's a progression that kind of models the use of algorithms and automation more generally in society. Which is the things that kind of get taken over by the algos first are sort of the things that computers are obviously better at than people. Right. So, you know, so first of all, there needed to be this era of automation, right, where just, you know, financial exchanges became largely electronic, which then enabled the possibility of, you know, trading becoming more algorithmic. Because once, you know, the exchanges are electronic, an algorithm can submit an order through an API just as well as a human can do at a monitor quickly.
It can read all the data.
Yeah. And so, you know, I think the places where algorithmic trading have had the greatest inroads and had the first inroads were in kind of execution problems, kind of optimized execution problems. So what I mean by that is at a large brokerage firm, for example, one of the lines of business might be on behalf of large institutional clients taking what we might consider difficult trade. So it's not like a mom and pop investor saying, I want to buy 100 shares of Microsoft. It's a large hedge fund saying, I want to buy a very, very large stake in Apple and I want to do it over the span of a day. And it's such a large volume that if you're not clever about how you break that trade up not just over time, but over perhaps multiple different electronic exchanges that all let you trade Apple on their platform. You know, you will, you will move, you'll push prices around in a way that hurts your, your execution. So, you know, this is the kind of, you know, this is an optimization problem. This is a control problem. Right. And so machines are better. We know how to design algorithms that are better at that kind of thing than a person is going to be able to do. Because we can take volumes of historical and real time data to kind of optimize the schedule with which we trade. And, you know, similarly high frequency trading, you know, which is closely related, but not the same as optimized execution where you're just trying to spot very, very temporary, you know, mispricings between exchanges or within an asset itself or just predict directional movement of a stock because of the kind of very, very low level granular buying and selling data in the, in the exchange machines are good at this kind of stuff.
It's kind of like the mechanics of trading. What about the. Can machines do long term sort of prediction?
Yeah. So I think we are in an era where, you know, clearly there have been some very successful, you know, quant hedge funds that are, you know, in what we would traditionally call, you know, still in the stat arb regime. Like so, you know, what's that stat arb referring to statistical arbitrage. But for the purposes of this conversation, what it really means is making directional predictions in asset price movement or returns. Your prediction about that directional movement is good for, you know, you have a view that it's valid for some period of time between a few seconds and a few days. And that's the amount of time that you're going to kind of get into the position, hold it and then hopefully be right about the directional movement and you know, buy low and sell high, as the cliche goes. So that is a, you know, kind of a sweet spot I think for quant trading and investing right now and has been for some time when you really get to kind of more Warren Buffett style timescales. Right. Like, you know, my cartoon of Warren Buffett is that, you know, Warren Buffett sits and thinks what the long term value of Apple really should be. And he doesn't even look at what Apple's doing today. He just decides, you know, I think that this is what its long term value is and it's far from that right now. And so I'm going to buy some Apple or short some Apple and I'm going to sit that for 10 or 20 years. Okay. So when you're at that kind of timescale or even more than just a few days, all kinds of other sources of risk and information. So now you're talking about holding things through recessions and economic cycles. Wars can break out.
So there you have to understand human nature at a level.
Yeah. And you need to just be able to ingest many, many more sources of data that are on wildly different timescales. Right. So if I'm an hft, my high frequency trader, like I don't, I don't, I really, my main source of data is just the data from the exchanges themselves about the activity in the exchanges. Right. And maybe I Need to pay. You know, I need to keep an eye on the news, right? Because you know, that can sudden cause. Sudden the CEO gets caught in a scandal or gets run over by a bus or something. That can cause very sudden changes. But I don't need to understand economic cycles. I don't need to understand recessions. I don't need to worry about the political situation or war breaking out in this part of the world. Because all I need to know is as long as that's not going to happen in the next 500 milliseconds, then my model's good. When you get to these longer timescales, you really have to worry about that kind of stuff. And people in the machine learning community are starting to think about this. We jointly sponsored a workshop at Penn with the Federal Reserve bank of Philadelphia a little more than a year ago on. I think the title was something like Machine Learning for Macroeconomic Prediction. Macroeconomic referring specifically to these longer timescales. And you know, it was an interesting conference, but it, you know, my, it left me with greater confidence that we have a long way to go to, you know, and so I think that people that, you know, in the grand scheme of things, you know, if somebody asked me like, well, whose job on Wall street is safe from the bots? I think people that are at that longer, you know, timescale and have that appetite for all the risks involved in long term investing in and that really need kind of not just algorithms that can optimize from data, but they need views on stuff. They need views on the political landscape, economic cycles and the like. And I think, you know, they're, they're, they're pretty safe for a while, as far as I can tell.
So Warren Buffett's job is.
Yeah, I'm not seeing, you know, a robo Warren Buffett anytime soon.
Should give him comfort.
Sa.
