A guide to investing in the AI ecosystem

The state of AI

Artificial intelligence (AI) has been around for a while, but it’s recently been thrown into the spotlight with the advent of ChatGPT. But to think that chatbots are all there is to AI would be to seriously underestimate its capabilities: artificial intelligence is the simulation of human intelligence by machines. It does things like understanding language, making decisions, recognizing patterns, learning from experience, and solving intricate problems.

AI is a technological revolution, and these follow a certain pattern:

Phase 1: The Beginning. A groundbreaking technology emerges and becomes a major trend.

Phase 2: Enthusiasm. As time goes on, it becomes harder to gauge the long-term impact of the technology.

Phase 3: The Inevitable Change. Just when confidence is at its peak, the bubble bursts.

Phase 4: Growth and Transformation. New developments emerge from the aftermath, giving rise to innovative businesses that benefit from the widespread adoption of the original technology.

AI is expected to significantly enhance productivity, increase corporate profits, and drive economic growth. Analysts at Goldman Sachs predict it could even boost US productivity growth by 1.5% per year over the next decade. That would result in a roughly 4% increase in S&P 500 profit margins during that time.

How AI can help with investing

One way to get in on the AI trend is by using the technology to inform your investments. As for how to do that, there are four main options:

Robo-advisors

If you're new to investing and prefer a hands-off approach, robo-advisors can manage your portfolio by selecting, allocating, and rebalancing your investments.

Quantitative trading models

For more advanced traders with a shorter investing timeframe, these models offer algorithm-based trading strategies developed from statistical analysis of historical data.

Risk-management system

These focus on minimizing potential portfolio risks by estimating the likelihood and market impact of specific events, and then suggesting ways to mitigate those risks.

Natural language processing (NLP) system

ChatGPT and Bard are examples of NLP systems. These can serve as tools for investment research, but they usually require user input for research prompts and may not always provide real-time data or factual information.

Alternatively, instead of using AI to help you invest, you could invest in AI and its ecosystem.

Investing in the AI ecosystem

Investing in AI can be direct or indirect – and if AI is truly revolutionary, its positive impact on productivity and profit growth will extend to a lot of different sectors, not only tech. Just keep in mind that it takes time for innovations to become widely adopted, so you might not see immediate economic benefits

The AI ecosystem consists of three groups:

Enablers

These are companies like Nvidia that supply crucial AI hardware and build the necessary infrastructure for AI technologies to function effectively.

In the initial phase of the AI revolution, these companies are likely to see immediate benefits as demand for their AI-related products surges. Investing in these "pick and shovel" companies might seem like a safer bet to start with: major semiconductor firms already have well-established businesses, making their stocks less speculative than some direct AI investments.

That said, while AI contributes to the growth of enabling companies, it doesn't make up the majority of their revenue. And these businesses can be cyclical – so they could face challenges in an economic downturn.

Plus, enablers probably offer less potential for significant gains compared to pure-play AI companies, even though they're dealing with similar competitive pressures and rapid technological changes.

Hyperscalers

These are Big Tech companies, responsible for scaling up AI solutions to a larger audience. Examples include Microsoft, Alphabet (Google), and Amazon.

In the last five years, Big Tech companies have largely seen their stock prices shoot up. With deep pockets, top-notch talent, and treasure troves of data, these giants are in a prime position to cook up advanced AI technologies that can be put to work in a variety of industries.

Big Tech firms are the ones laying down the software foundation, making it possible for other companies to whip up their own AI apps for specific needs – and that only adds to their influence. If AI spreads like wildfire, Big Tech is looking at some serious gains.

But it might be a while before AI starts making a meaningful contribution to Big Tech's bottom line. And who's to say if it's going to be a game-changer for these companies at all. Plus, as the costs of developing AI infrastructure plummet, Big Tech could face stiffer competition, and the AI landscape changes faster than you can say "machine learning."

Empowered users

Companies across wide-ranging sectors like Meta (formerly Facebook), Salesforce, SoFi, Hexagon, and Adobe leverage AI to enhance their products and services.

In the long run, numerous sectors are poised to benefit from widespread AI adoption. The extensive advantages of the technology will eventually lead to companies using it for productivity enhancement, potentially increasing their revenue and their profit margins.

Industries like software, consumer staples distribution, commercial services, and even biopharmaceutical companies could experience substantial earnings growth with enhanced labor productivity driven by AI.

There are pros and cons that come with investing in the AI ecosystem. Thus far, only a narrow group of “winners” – mostly in the tech sector – have seen large share price gains, but this is expected to broaden over time.

Risks and considerations

Just like with any other kind of investment, it's important to diversify when you're diving into the AI trend. Consider spreading your investments out across various subcategories, depending on things like how they’re valued, how much risk you're comfortable with, and how long you plan to invest for.

If you're in it for the long haul, you might lean towards investing in empowered users. They often give you the chance to invest at a lower price, letting you wait patiently for AI's positive impacts to start showing. On the flip side, if you're more of a risk-taker, you could explore enablers or hyperscalers – even if their valuations might seem frothy.

If you don’t know where to start, you could consider investing in an ETF like the iShares Robotics and Artificial Intelligence ETF (ticker: IRBO; expense ratio: 0.47%), Global X Robotics & Artificial Intelligence ETF (BOTZ; 0.68%), or the WisdomTree Artificial Intelligence UCITS ETF USD Acc (WTAI; 0.4%).

Right now, the biggest hurdle for AI's progress is regulation, which could impact all the different types of companies involved in the technology. Plus, as the AI hype keeps rising, there's a real chance of a market bubble forming.

But here's the good news: AI isn't going anywhere. If you haven't invested in it yet, don't worry – you're not too late to the party. A select few early birds might have already seen some gains, but there are plenty of opportunities left, including ones that could have the biggest payoffs in the long run.