As an equity investment advisor or portfolio manager, our investment philosophy is based on the principles of quantitative finance and the use of advanced machine learning techniques. We believe that by using quantitative models, we can identify patterns and trends that are often overlooked by traditional fundamental analysis. By analyzing large sets of data and applying statistical models, we can gain insights into the performance of individual stocks and the market as a whole. Here we will outline our approach to quantitative investment and explain the methodology behind it.
What is Quantitative investment?
Quantitative investment is a data-driven approach to equity investing that involves the use of mathematical models and statistical analysis to identify investment opportunities. This approach is based on the premise that the stock market is not completely efficient, and that there are patterns and trends that can be exploited to generate returns.
Traditionally, equity investing has been based on fundamental analysis, which involves analyzing a company’s financial statements, management team, industry trends, and other qualitative factors to determine its intrinsic value. This still continues to be the bedrock of how we approach investing. We strongly believe in our fundamental investment philosophy Roots & Wings. However, while fundamental analysis can provide valuable insights into a company’s performance, it is limited by the availability of data and the subjective opinions of analysts.
Quantitative investment, on the other hand, relies on large sets of data and statistical models to identify patterns and trends that are often overlooked by traditional analysis. By using machine learning algorithms, we can analyze vast amounts of data and uncover complex relationships that would be impossible to detect manually. This bestows us the ability to remove the influence of subjective opinions and biases. By relying on statistical models, quantitative investment is more objective and less influenced by the opinions of analysts or investors. This allows for more consistent decision-making and reduces the impact of human error.
Data Collection and Preprocessing
The first step in our methodology is to collect and preprocess data. We prefer to use annual reports of companies, which are publicly available and provide a wealth of information about a company’s financial performance. The data from annual reports that we crunch typically include financial statements such as income statements, balance sheets, and cash flow statements, as well as other information such as management’s discussion and analysis and notes to the financial statements. This data is available in India for a decent price and there are curated information sources that will save you the effort of screen scraping.
No matter how curated the data is, one still needs to clean and process it to remove any missing or erroneous data points, and to convert the data into a format that can be easily analyzed by our computer programs. The quality of the data is critical to the success of a quantitative investment strategy. Inaccurate or incomplete data can lead to incorrect conclusions and poor investment decisions.
The next step is to perform feature engineering, which involves selecting and transforming the data to create new features that are more relevant for analysis. Feature engineering is the process of selecting and transforming the data to create new variables that are more relevant for analysis. The goal of feature engineering is to create variables that capture the most important aspects of the data and that are predictive of future performance.
One of the most important aspects of feature engineering is the calculation of financial ratios. These include ratios such as price-to-earnings ratio, return on equity, and debt-to-equity ratio, as well as creating lagged variables to capture trends and momentum in the data. Financial ratios are calculated by dividing one financial statement item by another, such as dividing the net income by the total assets to calculate the return on assets. These ratios provide a standardized way to compare the financial performance of companies and are commonly used in fundamental analysis.
In addition to financial ratios, lagged variables can also be created to capture trends and momentum in the data. Lagged variables are created by shifting the values of a variable backwards in time, allowing us to capture changes in the variable over a specific time period. For example, we can create a lagged variable for the price of a stock that captures the change in price over the previous 30 days.
Feature engineering is thus a critical step in the quantitative investment process, as it allows us to create variables that are more relevant and predictive of future performance. There are techniques such as Principal Component Analysis (PCA) to auto-extract features by throwing a mountain of data at AI code and asking it to extract features. However, this brute force must be complemented with human experience to steer systems in the right direction. Otherwise, huge computing resources could get expended to arrive at not-so-great results. Finally, by selecting the most important variables and transforming them into a format that is suitable for analysis, we arrive at more accurate and robust models. At Jama Wealth, we crunch hundreds of features to arrive at suitable stock baskets.
Once the data has been collected and preprocessed, and the features have been engineered, the next step is to select a suitable model for analysis. Model selection is the process of selecting a suitable model for analysis. There are many different types of models that can be used in quantitative investment, including linear regression, decision trees, and neural networks.
However, we prefer to use machine learning models, which are designed to analyze large datasets and identify complex patterns. Machine learning models are particularly well-suited to the task of quantitative investment, as they can identify patterns and relationships that would be difficult to detect using traditional statistical methods. These models are able to learn from historical data and use that knowledge to make predictions about future performance.
It is critical that historical data fed to the model to validate results do not have survivorship bias; else the risk of cherry-picking goes up significantly. For example, decision tree algorithms that are very dense, i.e. have dozens of forks (or decision nodes) could betray survivorship bias.
Model Training and Backtesting
Before deploying the model, it is important to train and test it on historical data to ensure that it is accurate and robust. Model training is the process of using historical data to train the model to make predictions about future performance. This involves using a portion of the data for training the model and a separate portion for testing it. The training data is used to fit the model to the data, while the testing data is used to evaluate the model’s performance.
Backtesting is the process of evaluating the model’s performance on historical data to determine how well it would have performed in the past. This involves applying the model to historical data and comparing its predictions to the actual performance of the stocks. Backtesting is a critical step in the quantitative investment process, as it allows us to evaluate the model’s performance over time and to identify any potential issues with the model.
Once the model has been trained and tested, it is ready to be deployed for use in making investment decisions. The model can be used to identify undervalued stocks that are likely to outperform the market or to identify stocks that are overvalued and likely to underperform. The model can also be used to create portfolios that are optimized for specific risk and return objectives.
Model deployment is the process of using the model to make investment decisions. This involves applying the model to real-time data to identify investment opportunities and to make buy and sell decisions. The model can be used to create portfolios that are optimized for specific risk and return objectives and to adjust the portfolio over time as market conditions change.
The use of quantitative models in investment management has grown significantly in recent years, as investors have become more sophisticated in their approach to equity investing. By using quantitative models, we believe that we as portfolio managers or investment advisors can gain a deeper understanding of the market and identify investment opportunities that might otherwise be overlooked.
Advantages of Quantitative Methodology
There are several advantages to using the quantitative investment approach described above:
Objectivity: Quantitative models are based on statistical analysis and are therefore less influenced by subjective opinions or biases.
One of the primary advantages of quantitative investment is its objectivity. By relying on statistical models, quantitative investment is less influenced by the opinions of analysts or investors. This allows for more consistent decision-making and reduces the impact of human error.
Speed: Quantitative models can analyze large amounts of data quickly and efficiently, allowing for rapid decision-making.
Quantitative models are also much faster and more efficient than traditional methods of investment analysis. They are able to analyze large amounts of data quickly and accurately, allowing for rapid decision-making and the identification of investment opportunities that might otherwise be missed.
Consistency: Quantitative models apply the same rules consistently, reducing the impact of human error.
Another advantage of quantitative investment is its consistency. Quantitative models apply the same rules consistently, reducing the impact of human error and ensuring that investment decisions are made based on objective criteria rather than subjective opinions.
Transparency: Quantitative models are transparent, allowing investors to understand the underlying assumptions and methodology.
Finally, quantitative investment is transparent, allowing investors to understand the underlying assumptions and methodology. This transparency allows investors to evaluate the model’s performance and make informed decisions about their investments.
To sum up these advantages, quantitative investment is a powerful approach to equity investing that is based on the principles of quantitative finance and the use of advanced machine learning techniques. By analyzing large sets of data and applying statistical models, we are able to gain insights into the performance of individual stocks and the market as a whole. This approach provides several advantages over traditional fundamental analysis, including objectivity, speed, consistency, and transparency. In fact, it boosts the application of our Roots & Wings philosophy.
While quantitative investment offers numerous advantages, it is crucial to be aware of its limitations in order to maximize its potential. One significant limitation is that quantitative models are constrained by the availability and quality of data. These models may not capture all the relevant factors influencing stock prices, such as sudden shifts in market sentiment, regulatory changes, or unforeseen events like natural disasters. Incomplete or inaccurate data can lead to misguided investment decisions and potentially significant losses.
Another limitation is the reliance on past performance as a predictor for future results. While historical data can provide valuable insights, it does not guarantee future success, as markets are inherently dynamic and complex. Circumstances and trends can change, rendering past patterns and relationships irrelevant. Consequently, models based solely on historical data may not adequately anticipate new developments or adapt to evolving market conditions.
Overfitting is another concern when using quantitative models. It occurs when a model is excessively tailored to historical data, making it highly sensitive to random fluctuations or noise. Overfit models may appear highly accurate when tested on past data but often perform poorly on new, unseen data. This can lead to false confidence in the model’s predictive power and result in suboptimal investment decisions.
Therefore it is advisable to use quantitative models in conjunction with other methods of investment analysis, such as fundamental analysis and market analysis. Fundamental analysis approaches like ‘Roots & Wings’ evaluate a company’s financial health, management quality, and industry positioning, while market analysis examines broader economic trends and investor sentiment. Combining these approaches with quantitative models allows investors to gain a more comprehensive understanding of the market and make better-informed investment decisions.
In conclusion, the growing popularity of quantitative models in investment management signifies the increasing reliance on data-driven, objective decision-making. Quantitative investment harnesses advanced machine learning techniques to analyze vast datasets, allowing investors to uncover opportunities that may be overlooked by traditional methods. These models offer various benefits, such as more consistent decision-making, efficient data analysis, and enhanced transparency in understanding the underlying methodology.
However, it is crucial to recognize the limitations of quantitative investment and utilize it in conjunction with other investment analysis methods. Combining quantitative models with fundamental and market analysis can provide a comprehensive understanding of a company’s financial health, management, and broader economic trends. Regular monitoring and updating of these models are necessary to maintain their accuracy and relevance in the ever-changing market landscape.
Risk management plays a vital role in quantitative investment, as the models do not guarantee profits and always carry a risk of loss. Employing diversification and position sizing helps manage portfolio risk and minimize potential losses. With appropriate usage and understanding, quantitative investment can serve as a potent tool for generating superior returns in equity markets.
As technology continues to evolve, the future of quantitative investment is likely to become even more sophisticated, enabling investors to make better-informed decisions and achieve higher returns. By embracing quantitative models and addressing their limitations, investors can unlock new opportunities and navigate the complexities of the market with greater precision and confidence.
Stay updated with the latest market and investment updates. Join Jama Wealth on Telegram, Linkedin, YouTube, Instagram, Facebook, Quora for more!
For high quality investment advice and to grow wealth, download Jama Wealth App on iOS App Store and Android Play Store.