AI & MACHINE

LEARNING:
O P P O RT U N I T I E S A N D
RISKS IN INVESTMENT
Hai Ninh Duong
CONTENTS
o Why machine learning ?

o Application in investment: Gu, Kelly & Xiu (2020)

o Challenges and risks

 WHY MACHINE LEARNING ?
Given the vast amount of data available and increasing technological complexities, we
have seen more and more application of machine learning and AI in finance

ML is a subset of AI where ML models are built to handle complex high-dimensional

data and they are more flexible to functional form of the input/output relationships than
traditional models.

Moreover, ML models can uncover the hidden underlying relationship between

predictors and predicted variables that are unknown to the investors

Data

Evaluate Training

Prediction
 A P P L I C AT I O N I N I N V E S T M E N T
Paper: Gu, Kelly & Xiu (2020)
Motivation: use ML to predict the cross-sectional excess returns of equity. ML overcome the
limitation of traditional linear models where there exists a huge number of estimated parameters
and possible non-linear relationships.
Methodology:
Return data Feature set Models
Monthly returns of 920 predictors including Various neural network
30,000 stocks in the US firm-specific characteristics and regression tree
market from 1957 to and macroeconomic models are evaluated
2016 predictors against linear models

Main results:
 ML algorithms significantly outperform traditional linear models, indicated by higher out-of-
sample forecast of portfolios’ Sharpe value
 Feature importance across models reveals that recent price trends, short-term reversals and
stock momentum are consistently strong predictors of excess return.
 CHALLENGES AND RISKS
1. Overfitting

Given the short history of available data in finance, techniques to prevent overfitting such as cross-
validation or having holdout data may not be effective.

2. Explainability of complex models

The superior predictive power of ML comes at the cost of the difficulty to understand how and why
the models generate results.

Investors, therefore, unlikely to adjust their strategies during economic downturn, which potentially
exacerbates market volatility

3. Non-stationary markets

Investors who look for alpha-generating strategies face other investors with similar goals, each impact
the market differently and thus change the market conditions, resulting in short-lived ML-based
strategies.

Markets and investors continuously change over time, which questions the relevance of historical data
as training set for ML algorithms.
THANK YOU
Hai Ninh Duong (Ben)​
Email: hninhduong@gmail.com
Phone: +61 452 573 683