Investing Driven By Science

When people find out that I make a living trading, many times the discussion turns to investing.  Two of the questions that come up quite often are ” What do you think the market is going to do ?” and the related ” What do you think is a good investment ?”

Every day the financial news media is full of articles and interviews of people giving their opinion about what the market is going to do and where you should put your money.  These include Nobel laureates, billionaire investors, expert fund managers and last but not least the humble blogger or financial advisor next door.  Invariably the article or interview might include something on the lines of the guy (most of them are guys it seems) who predicted the last market crash or the guy who made a billions dollars in such and such market.  Fortunately some of the articles also mention that this same guy has been wrong so many times before.  It is also not uncommon to get diverging advice on the same day from different people.  So who do you believe?

A few years back I made the decision that I was going to base my decisions in life on facts and evidence.  I apply the same philosophy to my investing.  The challenge lies in that sometimes facts don’t mean a thing.  That’s right.  Facts can be totally random and meaningless.  So not only do we need to distinguish between facts and fiction, but we also need to differentiate between meaningful information and noise.  This is where science comes in.  Using mathematics, statistics, and the scientific process we can distinguish the fact from fiction and noise.

The Statistical Approach

If you were expecting a baby, I would not be able to tell you exactly how tall your baby was going to be when he or she grows up.  But if I knew the gender and some information about you and your partner’s heights, ethnicity, etc.. I could probably tell you with a certain degree of certainty the expected average height for your baby when they grew up.  This information would be based upon data collected from other babies that shared a similar background to your child and are now adults.

The same approach can be applied to financial instruments.  If you show me a picture of the market today and ask me: ” What is it going to do next?” I can never tell you with certainty.  However I can go back in time, have a look at other occasions when the market was in a similar situation and then come up with a probabilistic estimate of what the market is likely to do next.

A quantitative investing system looks at a particular situation in the market and asks the question:  “If I had invested in this market every time this situation occurred in the past, would I have made money or not?  If yes, how much?”  One can then compare this market situation to others and thereby decide which ones offer the better opportunities.

The quantitative investing approach involves the search for opportunities that offer a sufficient edge to the investor.  This means that although the investor will not make money every time, they will make enough money often enough to make it a worthwhile investment.

Thus the quantitative approach offers a systematic and repeatable approach to investing that gives the statistical edge to the investor.  Combined with proper risk management techniques, if they stay true to the system, in the long run an investor should be able to profit.

For an example of the quantitative approach applied to the S&P 500 you can read the posts The Quantitative Process Part I and The Quantitative Process Part II.

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