Ask any quant investor what his greatest edge is, and he’ll probably tell you it’s his computer’s ability to process vast amounts of data. That, in turn, allows the computer to identify patterns invisible to the human eye.
I’ve spent the past year and a half immersed in the world of quant investing, so I appreciate the power of computers to churn through reams of information.
But I don’t believe that raw computing power is quant investing’s most significant edge.
Instead, its edge is in offering a solution to the one problem even the most complicated mathematical algorithms can’t solve: the problem of human psychology.
Let me explain…
Investing’s Psychology Problem
When you begin your journey as a professional investor, you focus on a handful of skills.
You analyze financial statements. You learn to value companies. You master the Black-Scholes option pricing model.
Then one day, you have an epiphany.
You realize that successful investing is more about mentality than math.
The “current state of the market” is one giant Rorschach test.
What we perceive says more about us than what is really there. And chances are, our perceptions are distorted.
Modern finance has only started to acknowledge the importance of psychology through “behavioral finance.”
And that’s thanks only to Daniel Kahneman, the Princeton psychologist who won the Nobel Memorial Prize in economics in 2002. (Kahneman never took a single course in economics in his life.)
Behavioral finance takes the assumptions of modern finance and unceremoniously chucks them out the window.
Behavioral finance is all about the psychology of decision making.
Its fundamental insight is this: Humans suffer from a wide range of cognitive biases.
Any of these alone makes it extremely difficult to win in the markets. Together, they make it almost impossible.
Just a few examples are…
Confirmation bias: You tend to search for new information in a way that confirms your preconceptions. You shoehorn every market behavior into your preexisting model of the world. You shut out interpretations that contradict your existing beliefs.
Need-to-understand bias: You must have an explanation of what is going on with the markets. You blame the market’s behavior on politics, the economy, the coronavirus. The list of possible reasons is endless. You create what author Nassim Taleb has called a “narrative fallacy.”
Need-to-be-right bias: You’re smarter than the average bear. You have a Wharton MBA and 25 years of experience. You have conducted a thorough analysis, and you have an answer. You have a deep-seated need to be right. You don’t realize that successful investing has next to nothing to do with the quality of your analysis. It has everything to do with how you handle being wrong.
Degree of freedom bias: You are a trader with an engineering background. You’ve designed the perfect trading system. You’ve back-tested it and confirm you would have made 1,200% last year. You believe the more rules your system has and the more “degrees of freedom” you incorporate, the better the results. You fall into the trap of over-optimization.
Do you recognize any of these in yourself?
Quant Investing and Excising Human Psychology
I designed a trading system for the very first investment fund I managed in the 1990s. I had to load an IBM PC with the historical data from a CD.
It was only then that I could screen stocks, generate charts and back-test systems based on historical data. The combination of data and computing power allowed me to uncover anomalies in the market invisible to others.
Today, I have access to far more sophisticated software. These are programs that PhDs at the world’s top hedge funds would have spent tens of thousands of hours developing 20 years ago.
And in early 2020, I began developing my own swing trading system to profit from short-term moves in the market.
My Oxford Swing Trader research service targets double- and even triple-digit gains over short periods.
The results so far have been better than I expected.
Each day, my customized system triggers dozens of potential recommendations. I screen each of these and present only the best – those that have hit on multiple algorithms – to my subscribers.
In fact, on Tuesday, we booked gains of 32.6% in just seven days. And yesterday we captured a 16.3% gain after 15 days.
Quant systems aren’t human. They are not driven by fear, greed or any other emotion.
Removing human psychology from the investment equation is the real edge in quant investing.