Quantitative Investing: Definition, Strategies, Books, & Tips


This great guide is for you who want to learn all the basics you need to know about quantitative investing, without it being too advanced. The goal is to be able to help beginners get started with quantum strategies.

In this guide, we will go through what you need to know to get started investing quantitatively, give you some really good tips for success, and also suggest a couple of books worth reading that will help you take the next step as quantitative investors.

So, what is quantitative investing?

Quantitative investing is a collective term for investment strategies that invest in stocks or other securities based on historical data and different types of parameters, without involving human emotions or traditional analysis. It is sometimes also called mechanical investment or mechanical strategies.

In general, quantitative investment strategies as a group have succeeded in generating very good total returns over time.

And this is in many cases with very little work when it comes to analyzes and transactions.

These strategies may thus be suitable for those who do not want or can put a lot of time and energy into their investments.

But remember that no return is guaranteed (regardless of strategy), and that it is not certain that they will perform as well in the future.

Quantitative investment is a way to systematically understand the stock market and absorb what has worked well historically.

In short, it is robust and well-proven investment strategies that try to beat the average without a huge amount of work.

What one can say that all quantum strategies have in common is that they are based on sound principles and simplicity.

However, it is of course important to also be critical when it comes to quantum investment. The strategies are based on historical data, and it is required that they are tested over long periods of time in order to be able to obtain any reliable data or statistics.

They can, and probably will, underperform indexes over long periods of time to and from.

But the studies that have been done show that a long-term investor with quantum strategies as a basis has good opportunities to overperform the stock market in the long run, without doing a major or more thorough analysis work for that matter.

What is the goal and idea of quantitative investment?

Quantum investment is entirely a way of buying shares (or other assets) based on predetermined parameters and factors that have historically been shown to yield good results.

In many cases, these strategies are built up by combining standard (and simple) key figures, and then back-testing this to see how they have performed.

We could see quantitative investment as a form of further development of the extremely popular phenomenon of passive index investment.

Looks more at numbers than companies’ operations

Quantum investment is thus based on looking more at companies’ figures than their operations.

The strategies are based on following one or more predetermined key figures and parameters, and in addition, no further analysis is made of the company’s operations or future prospects.

Many investors are well aware that it is difficult to find stocks that perform really well, and to find the best ones, it is generally necessary to spend a lot of time on analysis, valuation, and thinking about the companies’ future.

But with a quantum strategy, on the other hand, it is possible to get a relatively good result through only a relatively small effort in the form of analysis and valuation work.

The idea of ​​quantitative investments is to act differently from other investors on the stock exchange, and to do so in as simple a way as possible.

What these strategies have in common is that they follow sound concepts and strategies that have historically given good results.

But because you act differently than the masses, it also means that there will be periods of underperformance.

Then it is required that you can control your emotions and not allow yourself to be psychologically influenced.

What quantitative strategies are there?

There are many different quantitative investment strategies, but we will go through some of the most common and popular ones below.

Remember that investment strategies can in principle change and develop indefinitely, and that their historical returns of course vary slightly depending on what time periods you look at, what the underlying assets are, and what the different rules / criteria for the strategy are.

In many cases, it is also the simplest strategies that perform the very best over a long period of time. There are, of course, exceptions, but as a general rule of thumb, this is something to keep in mind.

Just because a strategy is complex and advanced to implement does not automatically mean that it will generate a good return.

1. But first, how much to change?

There is also another aspect you need to think about. And that is how much you have to change in the “finished” strategies that already have a good historical return and are proven over time.

Namely, it has been shown that the average investor loses (ie underperforms against the strategy and index) by trying to beat the original strategy by making an active selection instead of relying on the strategy’s ability to select the investments.

But if you really want to be active in your decisions, you can simply take inspiration from the various strategies and implement them in your own strategy.

Quantitative investment strategies have in common that they are based on sound principles, so it is clearly a good starting point.

If you are active in your selection, however, you should be aware that it can lower your expected return.

2. Magic Formula

Magic Formula is a strategy whose goal is to find quality companies that are valued low. This is done by using the two key figures Return on Capital (ROC) and Earnings Yield (EY) as selection criteria.

This means that you can sort out companies with a high return (profit) that have a low valuation.

A relatively simple selection process is thus used, and the fact is that it is a great way to be able to produce investments that have the potential to be really good.

The historical return has been very good, really no matter where in the world you look. The strategy has been analyzed a lot over the years, and it is thus very proven. The average has been a 20% return per year seen across several different markets.

This strategy was created by investor Joel Greenblatt and presented in his book The Little Book That Beats The Market.

If you are interested in learning more about this magic formula, you can therefore read the book to get good information on the subject.

3. F-Score

F-Score is a strategy published in 2000 by Joseph Piotroski, and in short it involves investing in fundamentally strong stocks based on 9 different criteria.

The idea that Piotroski had was to create a very simple strategy that did not require any advanced analysis methods, but which could still outperform the stock market as a whole.

The strategy ranks companies based on their profitability, financial position, and efficiency by looking at the 9 different criteria.

Each criterion that is met gives 1 point, so the more that are met the higher the score – and many points thus indicate a potentially good investment.

The companies that have a score between 7-9 have historically been among the best to buy into.

The historical return for F-Score is very good, as Piotroski was able to show in his publication from the year 2000. In the American market, that strategy had given 23% per year between the years 1976 and 1996.

But also tests done after that have shown on good returns.

4. Net-Nets

Net-nets is a very classic strategy where the idea is to invest in low-value companies. A s.k. net-net is a stock that you can buy at a lower price than its NCAV (Net Current Asset Value), which is simply the company’s current assets minus total liabilities.

In short, this means that they can be bought at a lower price than the liquidation value.

The strategy was developed by investment legend Benjamin Graham, and the fact is that it was easier to find net-nets in the past.

It was simply more common with low-value companies in the past, and nowadays it can be difficult to find qualitative net-nets. Warren Buffett has also used net-nets as an investment strategy (then referred to as “cigar butts”).

Usually there is a good reason for a low valuation, and net-nets can involve great risks. It is therefore easy to go on mines if you invest in net-nets.

Therefore, be sure to pay attention to what you are investing in if you choose to follow this strategy.

The historical return for net-nets has been very good over several time periods and market climate, according to several independent studies (1, 2, 3).

Net-nets gave, for example, 27.7% per year 1950-2009, a full 38.7% per year during 1970-2013, and finally 35% per year 1985-2007.

5. Momentum & trend tracking

Investors have for a long time benefited from the fact that equities and other types of assets tend to follow various different trends in their price development.

The assets that have developed well in terms of price often tend to continue to do so in the future, and vice versa for those that have developed poorly.

In short, a price increase in e.g. a stock that it attracts more investors and speculators who help drive the price even higher (and more than justified in some cases) – in short, there is a certain inertia in the market, and trends thus have a tendency to continue a tag.

A momentum strategy means that you buy what has risen the most in price, and a strategy with trend tracking means that you buy what goes up in price and avoid (sell) what falls in price.

Usually you look at trends and momentum in the last (3-6) months or the last year.

If you follow a momentum and / or trend strategy, you will thus buy shares (or other assets) that have developed best during e.g. a 1, 3, 6, or 12-month period.

It is also possible to base the strategy on a so-called compound momentum, which is an average of several time periods, and it makes it possible to further improve the strategy’s return.

Effective way to create excess returns

This has been studied extensively over the years, and it has been shown that momentum and trend tracking are an effective way to create an excess return against the rest of the stock market.

Several publications (such as Two Centuries of Multi-Asset Momentum and A Century of Evidence on Trend-Following Investing, as well as two others: 1, 2) have shown that it has worked for the past 200 years.

The books What Works on Wall Street and Quantitative Momentum also mention that momentum is a very good strategy.

There is a clear momentum effect both within specific asset classes (eg between different shares), but also between different assets (eg between shares and fixed-income securities).

How momentum and trend look in each asset and between assets can then serve as a decision basis for what to invest in (what rises) and what to avoid (what falls).

Quarterly rebalancing & the best time in the strategy

A portfolio based on momentum should be rebalanced frequently (eg quarterly) and this is because momentum has a strong seasonal effect.

History has shown that it is wise to carry out the rebalancing in early March, June, September, and December to get the best development.

Momentum strategies tend to work best when the stock market has bad periods.

This could be seen, for example, during the poor stock market development of the 1970s and 2000s, when the global trend tracking strategy clearly outperformed the stock market.

Quality filter & compound momentum

This type of strategy should be combined with a quality filter to sort out the most risky and least quality companies. A common form of quality control is to use F-scores to assess the company’s quality.

Those with the lowest F-score are filtered out and left, they become more qualitative, which can thus possibly be good investments.

Momentum combined with a value or quality filter tends to be less volatile than a pure momentum strategy.

Momentum is a good component in itself, but by creating a composite momentum you can further improve the momentum effect.

In short, composite momentum means that you look at the price development over several time periods (usually 3, 6, and 12 months) and then you calculate an average of these.

6. Trending Value / Value Composite

Trending Value is a strategy that contains the concept of value composite where the idea is to combine several valuation measures with momentum and trend.

The valuation measures that are composite and used in the strategy are P / E, P / B, P / FCF, EV / EBITDA and Shareholder yield (direct return + share repurchase).

It is a well-known and popular quantitative investment strategy introduced in James P. O’Shaughnessy’s book What Works on Wall Street.

This combination of compound value has proven to give very good returns historically – and the fact is that it has been the best measure for finding cheap and good companies that over time give a steady return.

The combination of several measures to a well-balanced key figure thus performs better than (most) individual key figures.

Value composite thus ranks companies based on their compound value.

And then, for example, you can choose to invest in the 10-15 most affordable, keep them for 1 year, and then repeat the procedure again.

That in itself is a good basis to start from.

Combine value composite with momentum

By combining value composite with momentum, however, you get an extra good result – and is what is called trending value.

Value and momentum are in fact negatively correlated, which means that together they create a more even return.

In James’ book, he selects the shares based on their momentum and price increase over the past 6 months – ie. he first finds the most affordable shares according to value composite and then he buys those that have risen the most in the last six months (about 25 shares).

Historical returns for both trending value and value composite have been very good. The former gave, for example, a return of 21.2% per year between 1964-2009, compared with 11.2% per year for the stock exchange as a whole.

And value composite generated an annual return of 17.2% during the same time period.

In the book Value Investing by James Montier, he showed that the value composite strategy gave a 25% return per year during the period 1985-2007 with 30 shares in the portfolio that were rebalanced annually.

7. Deep Value (EV / EBIT (+ momentum))

The deep value strategy (also called EV / EBIT or The Acquirers Multiple) is classified as the best quantum strategy according to Wes Gray and Tobias Carlisle in the book Quantitative Value.

According to them, this is the best measure of how cheap a company is – and you then buy the absolutely lowest valued shares.

It is also very easy to implement, which facilitates the possibility of using it.

It has been shown that the company multiple EV / EBIT is one of the clearly best (if not the best) key figures for being able to find really cheap companies.

In the previously mentioned book, the authors go into how many investors over the years have used the key figure to find good investments.

The key figure has been used by investors such as Warren Buffett, Joel Greenblatt, and Carl Icahn.

If you want to get the most quality companies among the really cheap ones, you can also look at the shares through a quality filter.

As you are probably aware, quality can be assessed and measured in different ways, but an example can be an F-score that helps to sort out the least quality companies with the highest risk.

Historical returns for this strategy have, like many other quantum strategies, been very good.

Studies have shown an annual return of 21.3% during the period between 1950 and 2013 on the US stock market with annual rebalancing.

The Acquirer’s Multiple

The Acquirer’s Multiple differs slightly from the original strategy in that it uses operating profit (OP) instead of EBIT in the calculation.

The advantage of OP is simply explained that it can provide a fairer idea of the company’s valuation as it does not include non-recurring gains (NRI).

This variant generated an annual return of 18.6% between 1972 and 2017 with a portfolio consisting of 30 companies and annual rebalancing.

Combine with momentum

It is also possible to combine EV / EBIT with momentum in the share price.

The combined strategy thus buys the lowest valued shares according to EV / EBIT, which at the same time has the best momentum in price development.

This phenomenon that value and momentum together contribute to a higher return has been demonstrated several times, and it is thus something that can be implemented to advantage in this strategy as well.

8. Trendy quality

Return on equity (ROE) is a popular measure for finding quality companies.

Namely, it is what drives the profitability of the company’s operations, and if they have a high ROE, it is an indication of a quality company and thus also a potentially good investment.

Equally composite value (value composite), it is possible to combine different measures of quality and return to a better key ratio.

This is in the form of compound ROI (return on investment), which consists of a combination of ROE, ROA, ROIC, and free cash flow through equity (FCFROE).

If you then choose to combine composite ROI with the share price momentum, you can buy quality companies whose share price has developed well.

This can therefore be a very good strategy to use if you are looking for profitable growth companies that are liked by the market.

9. Trendy dividend

Dividend investing has long been one of the most popular investment strategies, but especially in recent years. It has also been a very good and profitable strategy over long periods of time.

But if you want to improve the return further in a dividend strategy, you can combine the focus on dividends with price momentum.

That is: you buy high-yielding companies whose share price has risen the most (during the last 6 months, for example), which means that you invest in shares that the market likes and thus trade up in price.

3 simple tips to succeed with quantitative investments

Quantum strategies are basically meant to be simple.

And here are 3 simple tips to succeed with this type of strategy.

Tip 1 – Study like a mad-man

You need to make sure you have a proper knowledge of the strategies you choose to follow.

Read about historical data and development, take part in tips from other investors who have followed these strategies, and simply form as good an idea of ​​the strategy as possible.

The more educated you are, the better the chances are for you to get a good return.

Tip 2 – Have patience, discipline, and a long-term focus

Quantitative strategies can be great to follow, but then you just have to follow them.

And to follow them, you need patience, discipline, and a long-term focus – through both good and bad times in the market.

If you manage to follow one or more quantitative investment strategies over time, you will most likely become a winner who is rewarded with a high return.

Therefore, make sure that you do not give up when times get worse, but instead think that it is part of the process required to achieve a good return.

Tip 3 – Dare to trust the strategies

Most quantum strategies have been mass-tested against historical data to arrive at the optimal approach. And you need to try to trust that the strategy will perform well.

If you have no faith in the strategy, there is no point in continuing to follow it.

Be prepared that there will be times when strategies underperform.

But it is in those times when it is extra important that you have a faith and dare to trust that they will perform better in the future.

Recommended books

There are several related books that I can highly recommend (in no particular order).

  • What Works on Wall Street – James O’Shaughnessy
  • Quantitative Value – Wesley Gray and Tobias Carlisle
  • Quantitative Momentum – Wesley Gray and Jack Vogel
  • Millennial Money – Patrick O’Shaughnessy
  • The Acquirer’s Multiple – Tobias Carlisle
  • Value Investing – James Montier
  • The Little Book That Beats The Market – Joel Greenblatt
  • Deep Value – Tobias Carlisle

Conclusion

Concluding remarks on quantitative investments for beginners

That was all for my guide to quantitative investment!

I hope you’ve now learned lots of new things related to quantum investment.

It is always good to have this knowledge. Whether you choose to follow a quantitative strategy or not. If you want to succeed in investments, it is important to constantly absorb new information.

Are you interested in learning more about quantitative investing? First of all, check out the books I recommend above.

They will be able to help you build on the knowledge you have now gathered. Do you want to learn more about general things in economics and finance? Take a look at our other educational material here on my site.

Remember that everyone has the opportunity to succeed well with their (quantitative) investments. It does not matter what knowledge you have before.

Or how much money you have. The important thing is that you read on, are long-term, and have discipline to follow the strategy.

And you, if you have not started investing yet, it is high time you started. The earlier you start, the better the interest-on-interest rate can work on.

Sources

https://arxiv.org/abs/1711.04837

https://jpm.pm-research.com/content/44/7/24/tab-pdf-trialist

https://books.google.se/books?hl=en&lr=&id=eNWNDwAAQBAJ&oi=fnd&pg=PR11&dq=Quantitative+Investing&ots=KvI7fX3UP8&sig=1SPQHwG9bCN6PqBpZLyNC5Jh4eU&redir_esc=y#v=onepage&q=Quantitative%20Investing&f=false

https://jpm.pm-research.com/content/35/3/106.abstract

https://www.ceeol.com/search/article-detail?id=749337&source=content_type%3Areact%7Cfirst_level_url%3Aarticle%7Csection%3Amain_content%7Cbutton%3Abody_link

http://proceedings.mlr.press/v119/chauhan20a.html

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3281447

https://www.taylorfrancis.com/chapters/edit/10.4324/9781315074122-8/quantitative-investing-jarrod-wilcox

https://books.google.se/books?hl=en&lr=&id=Dtf7DwAAQBAJ&oi=fnd&pg=PR7&dq=Quantitative+Investing&ots=hez5pkzFGx&sig=WtiA5ZQwS_qrpKCXw_tEcKIrwLA&redir_esc=y#v=onepage&q=Quantitative%20Investing&f=false

https://books.google.se/books?hl=en&lr=&id=YDFbDwAAQBAJ&oi=fnd&pg=PT5&dq=Quantitative+Investing&ots=JwqucdOewP&sig=AEXUih1rvdgeM9s-F0yn4x7SWbg&redir_esc=y#v=onepage&q=Quantitative%20Investing&f=false

Kevin

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