The rationale for a quantitative approach to investing was first described by James Montier in his 2006 research report Painting By Numbers: An Ode To Quant:
We humans are clearly possessed of a powerful drive to allow our instincts to override our models. Andrew McAfee at Harvard Business Review has a recent post, The Future of Decision Making: Less Intuition, More Evidence, which essentially recapitulates Montierâs findings in relation to expertise, but McAfee frames it in the context of human intuition. McAfee discusses many examples demonstrating that intuition is flawed, and then asks how we can improve on intuition. His response? Statistical models, with a nod to the limits of the models.
To apply this quantitative approach to value investing, we would need to find simple quantitative value-based models that have outperformed the market. That is not a difficult process. We need go no further than the methodologies outlined in Oppenheimerâs Ben Grahamâs Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishnyâs Contrarian Investment, Extrapolation and Risk. I believe that a quantitative application of either of those methodologies can lead to exceptional long-term investment returns in a fund. The challenge is making the sample mean (the portfolio return) match the population mean (the screen). As we will see, the real world application of the quantitative approach is not as straight-forward as we might initially expect because the act of buying (selling) interferes with the model
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- Simple statistical models outperform the judgements of the best experts
- Simple statistical models outperform the judgements of the best experts, even when those experts are given access to the simple statistical model.
- What am I paying you for if I can build the model portfolio myself?
- Isnât this what Long-Term Capital Management did?
We find it âeasyâ to understand the idea of analysts searching for value, and fund managers rooting out hidden opportunities. However, selling a quant model will be much harder. The term âblack boxâ will be bandied around in a highly pejorative way. Consultants may question why they are employing you at all, if âallâ you do is turn up and run the model and then walk away again.The response to these questions is as follows:
It is for reasons like these that quant investing is likely to remain a fringe activity, no matter how successful it may be.
- It takes some discipline and faith in the model not to meddle with it. Youâre paying the manager to keep his grubbly little paws offthe portfolio. This is no small feat for a human being filled with powerful limbic system drives, testosterone (significant in ~50% of cases), dopamine and dopamine receptors and various other indicators interesting to someone possessing the DSM-IV-TR, all of which potentially lead to overconfidence and then to interference. Youâre paying for the absence of interference, or the suppression of instinct. More on this in a moment.
- Iâm talking about a simple model with a known error rate (momentarily leaving aside the Talebian argument about the limits of knowledge). My understanding is that LTCMâs problems were a combination of an excessively complicated, but insufficiently robust (in the Talebian sense) model, and, in any case, an inability to faithfully follow that model, which is failure of the first point above.
We humans are clearly possessed of a powerful drive to allow our instincts to override our models. Andrew McAfee at Harvard Business Review has a recent post, The Future of Decision Making: Less Intuition, More Evidence, which essentially recapitulates Montierâs findings in relation to expertise, but McAfee frames it in the context of human intuition. McAfee discusses many examples demonstrating that intuition is flawed, and then asks how we can improve on intuition. His response? Statistical models, with a nod to the limits of the models.
Do we have an alternative to relying on human intuition, especially in complicated situations where there are a lot of factors at play? Sure. We have a large toolkit of statistical techniques designed to find patterns in masses of data (even big masses of messy data), and to deliver best guesses about cause-and-effect relationships. No responsible statistician would say that these techniques are perfect or guaranteed to work, but theyâre pretty good.And I love this story, which neatly captures the point at issue:
The arsenal of statistical techniques can be applied to almost any setting, including wine evaluation. Princeton economist Orley Ashenfleter predicts Bordeaux wine quality (and hence eventual price) using a model he developed that takes into account winter and harvest rainfall and growing season temperature. Massively influential wine critic Robert Parker has called Ashenfleter an âabsolute total shamâ and his approach âso absurd as to be laughable.â But as Ian Ayres recounts in his great bookSupercrunchers, Ashenfelter was right and Parker wrong about the â86 vintage, and the way-out-on-a-limb predictions Ashenfelter made about the sublime quality of the â89 and â90 wines turned out to be spot on.How do we proceed? McAfee has some thoughts:
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Overall, we get inferior decisions and outcomes in crucial situations when we rely on human judgment and intuition instead of on hard, cold, boring data and math. This may be an uncomfortable conclusion, especially for todayâs intuitive experts, but so what? I canât think of a good reason for putting their interests over the interests of patients, customers, shareholders, and others affected by their judgments.
So do we just dispense with the human experts altogether, or take away all their discretion and tell them to do whatever the computer says? In a few situations, this is exactly whatâs been done. For most of us, our credit scores are an excellent predictor of whether weâll pay back a loan, and banks have long relied on them to make automated yes/no decisions about offering credit. (The sub-prime mortgage meltdown stemmed in part from the fact that lenders started ignoring or downplaying credit scores in their desire to keep the money flowing. This wasnât intuition as much as rank greed, but it shows another important aspect of relying on algorithms: Theyâre not greedy, either).The quantitative value investor
In most cases, though, itâs not feasible or smart to take people out of the decision-making loop entirely. When this is the case, a wise move is to follow the trail being blazed by practitioners of evidence-based medicine , and to place human decision makers in the middle of a computer-mediated process that presents an initial answer or decision generated from the best available data and knowledge. In many cases, this answer will be computer generated and statistically based. It gives the expert involved the opportunity to override the default decision. It monitors how often overrides occur, and why. it feeds back data on override frequency to both the experts and their bosses. It monitors outcomes/results of the decision (if possible) so that both algorithms and intuition can be improved.
Over time, weâll get more data, more powerful computers, and better predictive algorithms. Weâll also do better at helping group-level (as opposed to individual) decision making, since many organizations require consensus for important decisions. This means that the âmarket shareâ of computer automated or mediated decisions should go up, and intuitionâs market share should go down. We can feel sorry for the human experts whose roles will be diminished as this happens. Iâm more inclined, however, to feel sorry for the people on the receiving end of todayâs intuitive decisions and judgments.
To apply this quantitative approach to value investing, we would need to find simple quantitative value-based models that have outperformed the market. That is not a difficult process. We need go no further than the methodologies outlined in Oppenheimerâs Ben Grahamâs Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishnyâs Contrarian Investment, Extrapolation and Risk. I believe that a quantitative application of either of those methodologies can lead to exceptional long-term investment returns in a fund. The challenge is making the sample mean (the portfolio return) match the population mean (the screen). As we will see, the real world application of the quantitative approach is not as straight-forward as we might initially expect because the act of buying (selling) interferes with the model
Greenbackd
http://greenbackd.com/