The Importance of Quantitative Investing
It is well understood that mathematics is the mother of all science. Numbers are everywhere, and the ability to see and understand them gives a true advantage in forecasting the future. Therefore, no wonder that we quantify and calculate everything whenever we want to know or achieve something. The same goes for investing, where it is crucial to know the future and to calculate correctly. Here we have quantitative investing or quant investing, for short. This approach to investing has been developing for decades now and is of considerable importance today.
The quantitative model of investing
The quantitative approach to investing is usually associated with using historical data to determine how certain kinds of stocks tend to act in certain market conditions. This is the basis for creating a complex mathematical model that should be able to predict how the stocks will do in the coming years.
Yet, accurate prediction of the future is not what quantitative investing aims at. Another one of the most important features of quant investing is its relative independence from the accuracy of predicted outcomes.
This independence is produced by the margin of safety which quant investing models have. This margin of safety is the difference between the intrinsic value of a stock and its current price, that is, what the investor would pay buying it. The more the value exceeds the price, the safer the investment is, as it takes many negative market fluctuations to drive the value down enough to create a loss for the investor. Additionally, this also means that when conditions are favourable, the gain is extremely high.
Thus, the main objective of the quantitative investing model is to correctly determine the stock’s intrinsic value. This is the purpose for which all the historical data is used, and nuanced mathematical calculations are made. Professional analysts known as quants create algorithms and develop computer models to make these calculations as precise as possible.
Quantitative vs. qualitative
There is a common distinction in various sciences between quantitative and qualitative. This distinction is present in investing as well. The quantitative approach has its qualitative counterpart. So, how do we tell them apart?
As mentioned, the quantitative approach pays attention to the stock, its intrinsic value, and price. On the other hand, the qualitative approach gets its name from emphasizing the quality of the company. This means that qualitative investing requires evaluating the company’s products and services, how it is managed, and other aspects that allow talking about the overall quality of the company itself.
The latter investing style is often associated with Warren Buffett’s value investing model. The key principles are all about determining the value of the company and forecasting how it will play out in the future.
Thus, quantitative investing is based more on the numbers and tendencies that these numbers reveal. In comparison, the qualitative model requires making predictions based on our assumptions regarding market needs and the company’s ability to deliver.
On the one hand, this makes quantitative investing more data-driven, as it is almost entirely based on data and calculations. However, on the other hand, data is needed for a solid qualitative investing model as well. To determine the quality of a company and public sentiment regarding certain products and services, one needs to analyze relevant data.
The strength of collaboration
One might wonder here which approach is better, quantitative or qualitative? The answer is that both have their strengths and weaknesses. However, the best thing is that they are not entirely mutually exclusive, meaning that one can combine both for the most value.
The quantitative investing model relies heavily on historical data, which makes it prone to mistakes due to completely new circumstances. Something historically unprecedented will not show up in the data, and not accounting for it might mean a loss. Therefore, it is good to supplement the model with qualitative considerations, especially those that relate to the new types of products and various innovations and changes in the way of life.
However, a qualitative approach on its own can be extremely risky. Firstly, it relies more on subjective determinations about value. Even when based on data, these decisions might involve too much bias or simply be not as informed as such high-stakes decisions should be. Secondly, lack of diversification makes the mistakes more heavily felt and losses greater.
Security is precisely what quantitative investing provides through diversification and emphasis on the margin between stock value and price. Thus, it is extremely important to add quantitative analysis to qualitative models as well, to rely less on the need to evaluate companies correctly.
The importance of utilizing quantitative investing models lies in the security that mathematical models can provide. Whatever overall investing style is chosen, using computers for accounting for high volumes of relevant data provides a major advantage for contemporary investors.
Mustafa Al Mahmud is the Founder and CEO of Gizmo Concept and also a professional Blogger, SEO Professional as well as Entrepreneur. He loves to travel and enjoy his free moment with family members and friends.