AI-Driven Alpha Decay: Algorithmic Homogenization, Reflexive Signal Erosion, and the Paradox of Intelligent Markets
For quantitative finance and AI-driven markets, this paper establishes theoretical and empirical foundations for the diminishing returns of AI in investing, with implications for systemic fragility.
AI-driven investment strategies are self-defeating at scale due to signal crowding, performative erosion, and Red Queen competition, reducing alpha half-lives from 5-7 years to 18 months at current adoption levels. Empirical validation shows a 42% increase in institutional portfolio convergence from 2013-2024.
We show that AI-driven investment strategies are inherently self-defeating at scale. As AI adoption rises, three mutually reinforcing channels -- signal crowding, performative signal erosion, and Red Queen competition -- compress excess returns. We derive the alpha half-life $h(ϕ) = \ln 2/[θ+ δ(ϕ)]$, where $θ$ is the natural mean-reversion rate and $δ(ϕ) = Nϕρa/λ(ϕ)$ is the AI-accelerated decay component, which is convex-decreasing in adoption. At current adoption levels ($ϕ\approx 0.7$, $ρ\approx 0.6$), the model implies signal half-lives of 18 months versus 5-7 years pre-AI. We establish four theoretical results. First, the alpha half-life theorem: signal lifespans are convex-decreasing in AI adoption. Second, a signal extinction cascade: beyond a critical threshold $ϕ^*$, the decay of one signal class triggers accelerated competition for remaining signals. Third, a Red Queen impossibility: in the monoculture equilibrium, net alpha is identically zero despite heavy AI investment. Fourth, a fragility-efficiency tradeoff: the adoption level maximizing price discovery strictly exceeds the level minimizing systemic fragility. Empirical validation calibrates portfolio convergence to SEC Form 13F filing patterns (99.5 million holdings, 2013-2024), documenting that simulated institutional portfolio convergence increases by 42% over the sample period. We examine simulated hedge fund return dynamics showing declining cross-sectional dispersion among AI-adopting funds, and simulate the 2010 Flash Crash to illustrate fragility consequences.