Earlier this week I wrote about James Montier, global equity strategist for Dresdner Kleinwort, and his contention that purely quantitative models outperform independent human judgment for a wide array of decision problems across many fields of expertise. You can read his whole article here: Painting By Numbers: An Ode To Quant. He gives examples of quantitative models outperforming experts in medical diagnosis, university admissions, predicting criminal recidivism, and even judging the quality of wines. When there is so much evidence of quantitative models outperforming exports, why are the former used relatively rarely?

The most likely answer is overconfidence. We all think that we know better than simple models. My own confession at the start of this note is a prime example of such hubris. The key to the quant model’s performance is that it has a known error rate, whereas our error rates are unknown.

And furthermore:

Grove and Meehl suggest many possible reasons for ignoring the evidence presented in this note; two in particular stand out as relevant to the discussion here. Firstly, the fear of technological unemployment. This is obviously an example of a self serving bias. If, say, 18 out of every 20 analysts and fund managers could be replaced by a computer, the results are unlikely to be welcomed by the industry at large.

Secondly, the industry has a large dose of inertia contained within it. It is pretty inconceivable for a large fund management house to turn around and say they are scrapping most of the processes they had used for the last 20 years, in order to implement a quant model instead.

Another consideration may be the ease of selling. We find it ‘easy’ to understand the idea of analysts searching for value, and fund managers rooting out hidden opportunities. However, selling a quant model will be much harder. The term ‘black box’ will be bandied around in a highly pejorative way. Consultants may question why they are employing you at all, if ‘all’ you do is turn up and run the model and then walk away again.

It is for reasons like these that quant investing is likely to remain a fringe activity, no matter how successful it may be.

Read more:  Painting By Numbers: An Ode To Quant

Earlier:

• James Montier: Quantitative Strategies Rule
• All posts tagged James Montier