How and why quantitative investing can help the individual investor

Do you want to make money from the stock market? I do. How do I do this? I am a big fan of narrowing the universe of stocks to choose from before you start to make your own investment decisions. My rationale is there is too much information and choice. By the time you can analysis the bulwark of the equities at a given point in time, the situation has changed. There are too many potential investments to consider. Even if your brain is a super computer, if you analysis stocks at any meaningful depth, you are behind the times.

Still not convinced? Consider this metaphor. I guess my first question to you,  is can you beat a computer Chess program of reasonable strength ?  If you can, at a  2700 level, then you do not need quantitative investing. I play chess at an expert level and I can not. I am certainly not going to learn the same lessons with investing. Think about this metaphor and what this means. It means with computers, you can leverage other people’s knowledge. You do not have to reinvent the wheel. This is my first recommendation. Use other people’s knowledge. However, not just any research, as every guy out there has a new letter. Use quantitative objective, testable scientific research.

Stock Screener vs. a Quantitative shop

The question is how do you quantitatively narrow your  selection of stocks and what objective determinate criteria do you use to to find a universe of stocks, so you can subsequently make subjective choices on your own?  Lets see how I approach this.

People often login to their favorite financial website, such as Yahoo finance  and run a stock screener. A filter based on selection criteria like PE or PS. Perhaps they read about the most important ratios in a book or article and want to apply this to a screen. They narrow the universe this way or at least a reality check on stock buys they are considering. This is not the way to pick stocks. Why? Because these ratios are like single musicians in orchestra. Only together with all the other ratios do they explain the whole and you can get the sense of the music.

Therefore, stock screeners are not the way to go.

The alternative to stock screeners are quantitative shops. These are academic researchers who consider all the value and fundamental date in unison. Then package their results in a useable form.  They consider the whole picture and have created a selection criteria that works as seen by the past results and long-term back testing. It is a scientific approach to investing.  Of course everything could change but over the long-term, however, if they have done their job correctly then the stocks they pick will outperform, and by a significant margin.

Many but not all institutional investors use this, these guys know how to make money. Almost no individual investors use this approach because they are not aware of it. It is rarely written about. Everyone in the mass media writes about investing news and mutual funds or techniques of trading. However, how often do you have specific advice about quantitative investing in a useable form?

Why are quantitative shops better than using a mutual fund?

Because Mutual funds are managed often buy young guys trying to prove themselves based on conventional methods. Maybe they have a CFA degree and ten years of experience as a junior fun manager, but this does not mean I would trust my hard earned dollars with them. It is just a resume.

Some do well for a while but in the long run many (most) underperform the market. When I was a stock broker I would always see the hot fund of the month being pushed. They would show some five-year return that allowed this fund (often a sector fund) to out perform the market. But everyone knows like Heraclius wrote ‘all is flux and fire’. Past performance means nothing unless it is ten years plus. Further the discipline for selecting the equities need to be consistent. What if the manager tries something new. Then the past will have little baring on the future as there are different set of variable. Or what if like the fund manager leaves or has  personal problems.

Even the mutual funds themselves have a human element, what if the Fund gets too big like Fidelity’s Magellan fund in the 1990s and it was like trying to navigate a battleship in a small canal. Its popularity changed the fund. Therefore, funds like stocks are not in my opinion dependable.

Many people diversity their funds, but basically they will approach the index over the long term as they are holding so many investments. Some fund are good and I like them. But I still prefer individual stocks based on my own criteia with the help of quantitative investment information, not some hot shot Wall Street fund manager. If I lose or make money I want it to be my fault or not.

Use a quantitative investment shop to pick stocks

You can narrow the universe to stock that have a significant chance of outperforming the market. It is clear and tested with back testing. Of course it is all probability and nothing, repeat nothing is guaranteed. But if you can use a quantitive shop you should be better than the blok who does not.

I do not recommend giving your money to a quantitative equity management firm, but rather do it yourself. I believe this for various reason.

What about technical trading and software? Use this, but first narrow your universe to under valued stocks so if your technical elves are wrong, you will not be in bad shape for a longer term.

Why is a few percentage points important in investing?

It is not the few percentage point advantage that you get, but rather the constancy. quantitive shops tend to produce selections that year to year, in bull and bear markets outperform with positive results. This means the market is down but the top selections are still up. Do not take my word for it, look at a few of these like . They also have information on potential shorts in a bear market.

Again why is this constancy factor important? Because if you are investor it is nice. But if you are a stock trader and want to make high profits and get rich the only way to do with, besides being lucky or very patient, is leverage. If you have a system that yields 10% a year, but every year, and leverage this 10 to 1 then you will be doubling your money ever year.

I am not recommending you buy stock options or use margin. I am just saying consider the theory of this. I personally use leverage, but I have worked with these ideas for many years.

When quantitative research firms fail investors

Results shown on quantitive investing page are aggregate results and if you buy and sell like a computer, exactly when the equity has been added or subtracted to the list. If you buy stocks from the list, you will get different results. However, the theory is still valid and you in all probability will outperform the market and do it with consistency. But I have lost money using quantitative picks by trying to be too much of a maverick investor and not systematic.

Also if you are using research that is not in a usable digestible form, rather it is just thrown at you than, it is no good either.

I recommend two quantitative research tools

  • – Developed at Yale and marketing privately. Relatively cheap.
  • MSN top ten picks – Free but no frills. If you are a small investor try paper trades with this at first. Also try leverage scenarios with paper trades.

Where is the human element in investing

There is a lot. Quantitive shops and moving averages just narrow the exogenous and endogenous variable to a manage level. Once you have your universe narrowed, then go to work. Pick stocks based on things like do you like the company and what they do etc.

Remember investing is work not play. I have always said trading stocks is the most fun you can have with your clothes on, but this is about your money. Earn money first and have fun latter. Have fun playing tennis or whatever you like (me I like chess, languages, traveling though Eastern Europe). However, when it comes to your hard-earned money, be wise and objective. This is why I back up my investment choices with quantitative investing research.