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Invest Like a Quant

Even seasoned investors sometimes have a hard time understanding what Steve Greiner does for a living. “Whenever I use the term quantitative investing, I tend to get a blank look,” he says. “Maybe they’re flashing back to a particularly tough calculus class.”

Steve leads the Schwab Equity Ratings® team within the Schwab Center for Financial Research, which evaluates stocks on their potential to outperform or underperform the market in the year ahead. And yes, his job involves a lot of math.

Quantitative investing is basically any method by which computers are used to sort through vast amounts of financial data in order to identify patterns from which investors can potentially profit. Quantitative analysts, or “quants,” implement mathematical models for any number of tasks, from assessing risk and predicting market movements to pricing derivatives and selecting securities. Quants also create trading models that help select securities when the investment horizon is very short, on the order of weeks or even days.

And while the field often involves complex and even arcane formulas that are literally and figuratively Greek to most investors, “the research of myriad academics, Ph.D.s and Wall Street whiz kids can prove valuable to everyone,” Steve says. “Don’t shy away from their insights just because you think they’re too technical.”

There are three key principles most quants adhere to—and from which every investor can benefit.

1. Stick with your plan

Investment professionals typically follow one of several well-established philosophies, depending on their goals and appetite for risk. For example, value investors actively seek stocks they believe the market has underestimated, while growth investors focus capital appreciation and earnings growth. But whatever their approach, effective managers stick to their principles, in good times and bad, in bear markets and bulls.

“That might seem simple, but it’s not,” Steve says. For example, investors are naturally averse to selling an asset at a price below that which they paid—the so-called sunk-cost effect. In addition, individual investors tend to chase historical rather than expected returns; choosing last year’s top-performing mutual fund, for example, no matter its future prospects. “There are no guarantees of repeat success,” he says.

“Quants, on the other hand, remain objective by turning their investment process over to algorithms,” Steve says. “Investors similarly need to pick a system and stick to it, because with patience, any good strategy can see rewards.”

2. Focus on the fundamentals

Another staple of quantitative investing is its focus on fundamental metrics such as dividends, earnings, profit margins and revenues. No two quantitative models are alike, but all quants by definition deal in data they can measure. “They may integrate forecasts like earnings estimates,” Steve says, “but they also recognize that forward-looking data is not empirical; in fact, it’s highly subjective.”

In particular, Steve suggests that investors carefully examine not just dividends and earnings but also a company’s price-earnings ratio (the current share price divided by the earnings per share) and its price-to–book value (the current share price divided by the latest quarter’s book value* per share). “These criteria shine a light on a company’s valuation and fundamentals, which are critical for investors looking for long-term appreciation,” Steve says.

Indeed, fundamentals alone should keep investors from chasing fads; a company that makes a product they personally like, for example, or a hot initial public offering without a proven track record. “Of course, such investments can sometimes pay off,” Steve says, “but most long-term investors should focus on fundamentals first, especially if your investment horizon is long.”

3. Diversify, diversify, diversify

A third area where investors can learn from quants is in selecting the right mix of stocks, bonds and other types of assets. Many investors know the power of diversification, but quants delve deeper by estimating the risks of each specific asset class.

Investors prioritizing aggressive growth, for example, might inadvertently be overweight in technology stocks, putting them at risk should another tech bubble burst. Many quant models, by contrast, distribute dollars across equities chosen precisely because they don’t move in lockstep. It’s the same principle as asset-class diversification: Try your best to offset losses in one area with gains in another.

In particular, investors should ensure they’re not overly concentrated in a single asset class, sector or even stock. “Luckily, investors today have access to index funds that are themselves diversified within a specific asset class, sector and even region,” Steve says. A financial consultant can also help ensure adequate diversification across and within asset classes.

A formula for better investing

While the nitty-gritty of quantitative investing can challenge the best of us, we can all benefit from the insights quants bring to the investment world: Stay the course, mind the fundamentals and diversify not just across but also within asset classes. This approach might not be based on a proprietary algorithm, but it can be just as powerful.

Decoding quants

For an example of just how complicated mathematical modeling can get, look no further than the Benjamin Graham Formula. It can help determine whether one stock is likely to outperform another stock in the future based on the historical relationship between stock returns and other factors:

  1. Moderate ratio of stock price to assets
  2. Earnings stability over 10 years
  3. A steadily improving dividend record
  4. Earnings growth over 10 years
  5. Moderate valuation based on earnings to price
  6. Moderate valuation based on book value to price
  7. Adequate size of the enterprise

 

1. Working Capital, 2. Earnings Strength, 3. Dividend Yield, 4. Earnings Growth, 5. Earnings to Price, 6. Book Value to Price, 7. Market Capitalization

Q&A with a quant

Steve Greiner—senior vice president of Schwab Equity Ratings and the author of Ben Graham Was a Quant—answers our most-pressing questions.

Why don’t more people embrace quantitative investing?

First, it’s fear of the complicated. Second, quants got a really bad rap when they were unfairly criticized for causing the Great Recession.

Did they see it coming?

Unfortunately, I don’t think mathematical models ever will be able to predict extreme events—or at least not losses due to cataclysmic market failures.

How about limiting losses?

If correctly implemented in normal market environments, the steady application of quantitative-investing principles is designed to help mitigate portfolio losses.

Any advice for the budding quant?

If I were a 16-year-old who wanted to prepare for a quantitative investing career, I’d study physics and statistics. But you don’t need a formal academic education to gain expertise.

*The value of a business according to its balance sheet.

What you can do next

  • Want to do your own research? Learn about the resources Schwab has to offer.
  • If you’re a Schwab client, use the Portfolio Checkup Tool to see if your real asset allocation matches up with your target allocation.
  • Want to benefit from a quantitative investing approach with help from Schwab? Schwab Intelligent Portfolios® uses automation and algorithms to build, monitor, and rebalance an investment portfolio for you, while Schwab Intelligent Advisory™ offers managed portfolios with professional guidance.
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Schwab Intelligent Portfolios accounts must maintain a minimum balance of $5,000 to be eligible for automatic rebalancing.

Schwab Intelligent Advisory™ is made available through Charles Schwab & Co., Inc., a dually registered investment advisor and broker-dealer.

Please read the Schwab Intelligent Portfolios disclosures brochures for disclosures, pricing and other important information relating to Schwab Intelligent Portfolios.

Schwab Intelligent Portfolios is made available through Schwab Wealth Investment Advisory, Inc. (SWIA), a registered investment advisor. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. (CSIA). Free credit balances are swept into deposit accounts at Charles Schwab Bank (Schwab Bank). Brokerage products and accounts are offered by Charles Schwab & Co., Inc. (Schwab), Member SIPC. CSIA, SWIA, Schwab Bank and Schwab are separate but affiliated companies and are subsidiaries of The Charles Schwab Corporation.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Schwab Equity Ratings and general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S. headquartered stocks using a scale of A, B, C, D and F. Schwab’s outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Each of the approximately 3,000 stocks rated in the Schwab Equity Ratings universe is given a score that is derived from several research factors. The assignment of a final Schwab Equity Rating depends on how well a given stock scores on each of the factors and then how that stock stacks up against all other rated stocks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, their accuracy, completeness or reliability cannot be guaranteed.

Investing involves risk, including loss of principal.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

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