Which investment methods are best? Financial analysts, money managers, and financial media have always argued about this question. And as you probably know, they continue to argue. So what IS the best solution?
Many individuals simply choose to believe someone they've heard on television, or maybe someone their company suggested. They also famously tend to change their mind every few years as to what is the best investment choice, likely because it has performed well in the most recent short period of time.
The following three major methods of investment management are the most widely used by money managers: Modern Portfolio Theory, Asset Allocation, Market Timing and Fundamental/Technical Analysis. They all have their pros and cons -- and they all fail to provide consistent returns while minimizing risk.
However, thanks to new technological advances, we now have highly effective tools that help us get much better results: With sophisticated and powerful computers, a new breed of smart money managers now study exactly which indicators have worked under past market conditions and exactly which elements of each method have been successful. This approach allows them to combine the best of all worlds, with results to match. The methodology is called "Formulaic" or "Quantitative" investing.
So here are the principles of "Quantitative" investing and how to use them to approach investment formulas:
1) Set up investment rules...i.e., if this happens then I will do that.
2) Research past market conditions, purely with statistics, and record the performance that followed.
3) When patterns become clear, make a note of them and have them monitored via computer programming.
4) Based on these patters, investment allocation and individual security selection is determined. It is purely formulaic. No human emotion interferes with that process, and the names of companies are not considered either. You are simply looking for the right allocation and the companies that have the right price and the desired fundamental qualities.
5) When a company has been selected, it is held until it no longer meets the requirements. At that point, it will be deleted from the portfolio immediately.
Each model is "back-tested" by using data from previous years and even the previous day. This allows the recreation of exactly what a particular model would have looked like under various good and bad market conditions. In this way, money managers can calculate the probable return, volatility as well as the overall risk/return ratio of each model. And the results speak for themselves.