Tuesday, September 16, 2014

Quant vs. fundamentals: Should you drop out of college?

I was talking to a young analyst the other day trying to explain the difference between quantitative and fundamental analysis. Consider the following thought experiment: Would you drop out of college if a really good opportunity presents itself? What would be part of the thought process in making that decision?

Here is the quantitative approach. Liberty Street Economics, the blog of the New York Fed, wrote a series of posts about the value of a college education. In Part 1, they outlined the value of an undergrad degree in various ways. The most important is how the NPV of a Bachelor's Degree in constant dollars have evolved over the years:

In Part 2, Liberty Street Economics discussed the ROI of a Bachelor`s degree if you completed it in more than four years. Needless to say, ROI is negative if you drop out, especially if you are saddled with student debt.

In Part 3, which I won`t show, they suggested that if you are an underperformer, the value of a Bachelor`s degree may be no different than a high school education. In Part 4, they discuss the evolution of the job market for college graduates over the years.

Based on these quantitative (statistical, think "Big Data" style) studies, the typical student would be much better off staying in college than dropping out. That would be the "safe" bet to make - and no doubt the decision that most parents would encourage.

The limitations of models
On the other hand, consider the exceptions to the rule - that's when statistical models fail. Business Insiders recently featured a story of dropouts who became Tech billionaires. Names like Gates, Dell, Zuckerberg and Jobs topped the list. Shouldn`t that be part of the decision process on whether to drop out?

That`s where quantitative and fundamental analysis part company. Quants tend to bet on a model which give them a statistical edge. If you make hundreds or thousands of diversified bets, you will win - on average. As an example, my call on February 24, 2009, shortly before the ultimate March stock market bottom, to buy low-priced stocks with insider buying (see Phoenix rising?) was a quantitative and statistical call. There were both winners and losers in the suggested portfolio. Investors who heeded my advice would have seen somewhere between a double or triple on their money a year later.

On the other hand, a fundamentally driven investor will say, "In this case of whether to drop out, I have a single decision that's an undiversified bet. While I understand the statistics of the NPV of college degrees, etc., I need to drill down and understand the key drivers of success of the Gates, Dells, Zuckerbergs and Jobs of the world."

One fairly consistent element is that these "superstar winners" generally had an identifiable plan or path while they were undergraduates. As an example, Michael Dell was selling computers out of his dorm room. It helps that he had an entrepreneurial streak. Wikipedia recounts the story:
Dell attended Memorial High School in Houston, selling subscriptions to the Houston Post in the summer. While making cold calls, he noted that the persons most likely to purchase subscriptions were those in the process of establishing permanent geographic and social presence; he then targeted this demographic group by collecting names from marriage and mortgage applications. Dell earned $18,000 that year, exceeding the annual income of his history and economics teacher.
In this case, Dell quit to pursue his business plan.

It also helps that the successful dropouts went to a top school (think Harvard, Stanford, M.I.T., etc.). The field of concentration doesn't necessarily have to be in technology. Conceivably, the potential dropout could be a performing arts prodigy attending a prestigious institution like Juilliard and could go on to be the next Joshua Bell, Yo-Yo Ma (both of whom graduated, BTW) or Dustin Hoffman (who was a college dropout).

Quite simply, fundamental analysts focus much more on understanding the specific risks of a situation, but they don't have the same bandwidth as the quantitative analyst who looks for a statistical edge and accepts that he will be wrong in any one situation. A good fundamental investor understands his bandwidth limitations and a good quant understands his model's limitations. As it turns out, this analysis of freestyle chess indicates that a combination of the two appears to be the best approach:

  • Fundamental analysts can leverage the computer’s ability to gather data and crunch numbers.
  • Quantitative analysts can leverage the analyst’s ability to sort causality and detect patterns.

So should you drop out? That depends. In what way are you similar to a Bell, Ma, Hoffman*, Gates, Dell, Zuckerberg or Jobs**?

Bill Gates

* Check out this video of the story of Jonathan Goldsmith, who competed with Dustin Hoffman for roles, but wound up driving a garbage truck to make ends meet.
** Also see this advice from Todd McKinnon, CEO of a $600 million start-up.

1 comment:

Stuart Gordon Reid said...

As a quant who holds fundamental analysis in high regard, I really like this analogy. Thanks for sharing!