Look at the bigger equity picture: AI beyond tech

Davis: Our research, perhaps surprisingly, does not suggest that you should overweight tech stocks. If an investor is looking to take advantage of the growth predicted by the evolution of AI, the first order of business is to overweight the broad equity market—the U.S. equity market. I say the U.S. equity market because that’s where the strength of the growth will likely be given the vibrant source of innovation that the U.S. economy has been and seems likely to continue to be. 

Davis: That’s correct. First, you have to consider that tech stocks in general are very highly valued currently—much of that potential upside is already priced in. Secondly, the tech sector, as a whole, does not outperform during these periods of technological transformation, historically. We’d expect some future stars to emerge, but there will be a larger percentage of those in the sector that flop. For every Amazon that emerged from the internet bubble, there were dozens of start-ups that failed. 

Davis: That gets to the second reason you’d want to avoid overweighting tech. If our thesis is correct, and AI is a transformative technology with positive economic outcomes, we’d expect to see AI’s influence emerge in sectors outside of tech—health care, finance, manufacturing, etc.—driving increases in growth and productivity across the economy broadly. For example, electricity was a transformational technology, and it influenced sectors of our economy well beyond energy. For that reason, we’d suggest that if you want to bet on this outcome, the preferred way to do so is by increasing your equity exposure, not by overweighting the tech sector.

Davis: Our megatrends research suggests a lower probability of a scenario in which AI’s impact is minimal: only a 30%-40% likelihood of occurring. Then, you’re in a world where you might think about backing off equities and increasing strategic allocations to fixed income. Value stocks are also likely to outperform growth stocks in this environment because growth firms will be up against a major headwind of a secularly low-growth environment—historically, growth stocks that can’t grow earnings (for whatever reasons) generally end up with a significantly lower valuation. Value stocks, on the other hand, may come into favor (after a very long underperformance) and outperform the broader equity market.

Davis: Pay less attention to headline-grabbing statements around concentration in just a handful stocks, such as the Magnificent 7, or a particular sector, like tech. When it comes to the stock market, two seemingly contradictory statements can both be true. On one hand, large-cap (generally growth) stocks have a lot of staying power for longer than some might think—so the concentration could continue. On the other hand, these enterprises generally do not hold onto their position and growth mode for more than a few decades. Look at a list of the largest S&P 500 members from a few decades ago and compare that to today. Similarly, where were most of the Magnificent 7 stocks just 20 years ago?

How do investors navigate this? A simple but effective way is to own the total stock market, with a broadly diversified index fund. Another way is for the investors with active risk tolerance to work with active managers who can spot the decadal sea change and identify spectacular winners for the coming decade early on.

• Diversify beyond tech: Tech stocks are highly valued currently, as the tech sector is the epicenter of the potential AI transformation. But, even if AI becomes transformational and catapults the U.S. economy into a high-growth environment, the source of corporate profitability may broaden to other sectors: health care, finance, and manufacturing. Many of these are considered value stocks in the current market environment, so don’t count value out.

• Be mindful of the downside: There is a meaningful chance (30% to 40%) that AI’s impact might be minimal. If AI advancements are slower than we project, and productivity growth and economic expansion end up being disappointing, a strategy that tilts to fixed income and value stocks would be more sensible.

• Own the haystack or go for the needle with the right talent: One way to play both offense and defense is to own the entire U.S. stock market, with a broadly diversified index fund. This way, whether growth continues to outperform or value comes back after a long hiatus, the investor is reasonably positioned. For investors willing to take some active risk, it would be critical to work with managers who have the skills to identify winners early on and spot decadal sea changes, also early enough.